The long-awaited market reaction to accelerating US debt and uncontrolled deficit spending has arrived.  Standard & Poor’s issued a blunt warning today that it will re-evaluate America’s credit rating in the near future unless Washington acts to control its red ink, and that a lower rating — and therefore higher interest payments — is under consideration:

Standard & Poor’s cut its ratings outlook on the U.S. to negative from stable while keeping its triple-A rating on the world’s largest economy.

Relative to its AAA-rated peers, the U.S. has very large budget deficits and rising government indebtedness, and the path to addressing those issues is unclear, S&P analysts said.

“More than two years after the beginning of the recent crisis, U.S. policy makers have still not agreed on how to reverse recent fiscal deterioration or address longer-term fiscal pressures,” said Standard & Poor’s credit analyst Nikola G. Swann.

If a meaningful agreement to address medium- and long-term budgetary challenges isn’t reached and implementation isn’t begun by 2013, it would render the U.S. fiscal profile meaningfully weaker than its AAA-rated peers, analysts said.

Wall Street has reacted predictably.  The Dow dropped 200 points (1.8%) in the immediate aftermath of the announcement, and 29 of its 30 components fell backward.  The S&P lost 1.6%, and NASDAQ lost 1.8%, and all three indices gave no indication that they would recover quickly today.

What exactly does this mean?  S&P rates bonds, including Treasuries, for the risk they pose to investors.  A rating of AAA means the least amount of risk, so those selling the bonds — basically, debt — offer lower yields (interest rates).  This allows corporations and governments to borrow money less expensively, but only as long as their finances convince bond rating firms like S&P that the risk remains low to creditors.  A drop in the US rating means that we will have to offer higher yields, which means higher debt payments, and that will worsen our deficit problems as we borrow more money.

S&P isn’t looking for a commitment to end deficit spending altogether.  They want to see the trajectory of debt-to-income shift soon, and permanently, in order to keep assuring investors in the financial stability of the US government.  This is a warning that a recalculation will happen soon if Washington refuses to act, and it will also act as a warning to bond purchasers to avoid US Treasuries in the short term.