The change in the rating outlook of the US government debt to negative came as a surprise to markets. Suddenly risk assets were discarded in favour of the traditional safe haven assets – not least gold. This was the first time that S&P have taken this action and, while reaffirming the triple A status of US government bonds, the outlook suggests that there is a one in three chance that the rating will be lowered within the next two years, unless action is taken.

There are two elements to the stance S&P have taken. In the short term there is the prodding of political will power to push through an austerity programme that we Europeans have now become accustomed to. In fact S&P state: “We believe there is a material risk that US policymakers might not reach an agreement on how to address medium- and long-term budgetary challenges by 2013; if an agreement is not reached and meaningful implementation does not begin by then, this would, in our view, render the US fiscal profile meaningfully weaker than that of peer ‘AAA’ sovereigns.”

The timing of this outlook change is therefore interesting in this respect. It looks as though this is a pre-emptive position taken by S&P to inform politicians that the “last chance saloon” is fast approaching – and, if this opportunity is missed, the severe possibility of a rate cut could be on the cards. This would probably be catastrophic for both equity and bond markets.

Given the rate of debt build up it is difficult to see how the US can remain an AAA rated nation. From a position whereby the general government deficit stood at between three per cent and five per cent of GDP, just seven years ago, the deficit has now ballooned to over 11 per cent with no clear signs of reduction. Wars, social benefit schemes and, more recently, bail outs of many financial companies have largely been the cause of this debt explosion.

Meanwhile the focus has remained on providing stimulus to the economy rather than reigning in the deficit – thereby postponing crunch time. As Bill Gross of Pimco recently showed by selling all his US Treasury holdings, there is simply too much risk in US treasuries at this point in time.

In the longer term the generosity with Medicare and Medicaid remain major drains on cash for the country. According to S&P, in 2011 Medicare and Medicaid accounted for over 42 per cent of federal government spending. Market players, though surprised by the timing, were not particularly surprised with the statement.

This has been on the cards for some time and the rating agencies have threatened this before. When in 1996 Moody’s took a similar stance to that being taken by S&P, the US government reacted swiftly to cut the deficit. One hopes politicians will grasp this opportunity but with an election in 18 months time this doesn’t look hopeful.

Ironically on the day this news was released, the US dollar gained over 1.3 per cent against the euro. Perhaps this was more a reflection of the woes in the euro area rather than the strength of the dollar. The gains made by the True Finn (euro sceptics) Party in Finland’s general election served as a reminder of the potential difficulties that the EU may be faced with if it continues down the bailout route. Finland has the right of veto on such plans.

Closer to home, divisions appear in strategy direction within the ECB. Michael Bonello, Governor of the Central Bank of Malta was quoted by Bloomberg (April 18) as saying “policymakers mustn’t raise interest rates at the expense of economic growth in debt-strapped euro area nations if inflation expectations remain contained”. The ECB on the other hand believes that risks to growth remain on the upside and that the prospect of inflation is a real one. Hence it is unlikely that this will be the last interest rate rise this year.

Curiously Mr Bonello also said: “The sovereign debt crisis is not yet behind us, and the banking sector in some countries – which is a key to finding a solution to the crisis – is still very fragile”. He added: “We could still see an accentuation of the negative feedback loop from the financial sector to the real economy via the sovereign debt channel. The risks to growth could well be tilting to the downside.”

Clearly the debate between the core and the periphery in Europe is not going to go away. Two-speed Europe is currently a fact and while it is natural of Mr Bonello to fight his corner, interest rates are on the way up again. This is not good news for the government of Malta as the only issuer of bonds at this point in time.

Any increase in yields on euro government debt is likely to have an immediate impact on the price the local government pays for its debt. Remember that the pricing of local government bonds is directly linked to the German bunds. This does not sit comfortably with the level of debt the government is currently servicing.

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This article is the objective and independent opinion of the author. The information contained in the article is based on public information. Any opinions that may be expressed here above should not be interpreted as investment advice, nor should they be considered as an offer to sell or buy an investment. The company and/or the author may hold positions in any securities that might have been mentioned in this report. The value of investments may fall as well as rise and past performance is no guarantee of future performance. Curmi & Partners Ltd are members of the Malta Stock Exchange and licensed by the MFSA to conduct investment services business.

Mr Curmi is managing director of Curmi and Partners Ltd.