In the news doldrums of August, US rating agency Fitch caused quite some commotion when it unexpectedly downgraded America’s debt status from AAA to AA+. From a retail investor’s standpoint this is about as significant as when the best student in class gets an A- for once on a piece of homework. A cause of Schadenfreude perhaps, but hardly a result that will cause a dent in the student’s final grades.
Yet it hurt America’s pride, to judge by the reaction of the Biden administration and most US economists. Luminaries like Nobel-laureate and New York Times columnist Paul Krugman, academic and economic adviser of the Insurance behemoth Allianz Mohamed El-Erian, ex-US Treasury Secretary and Harvard professor Larry Summers and many others were exasperated and called Fitch’s decision “absurd”, “arbitrary” and “irrelevant”, “saying more about Fitch than the United States”. (Be reminded of the triple-A rating of tranches of US mortgage-backed securities, which proved to be worthless and pushed the world into the Great Financial Crisis.)
Admittedly the rating downgrade will have little influence on investment decisions. US treasuries are the bedrock of our financial system, “the most liquid, coveted asset class on earth” (Bloomberg), the definition of risk-free investment, and the base price for all other financial assets. There’s nowhere, as far as I know, where a fund manager’s mandate says “we only invest in triple-A sovereigns”. They wouldn’t have many countries to pick from. Only a handful of countries are still ‘best of breed’: Germany, Switzerland, Australia, Singapore and Norway come to mind. We retail investors in search for yield have long abandoned them. For us, lowly-rated BBB+ companies like Citigroup, Volkswagen or GM may do. This is not investment advice!
It is also unthinkable that the United States could involuntarily default. The country is master of its own currency, the world’s preeminent reserve currency for that matter, and can ‘print’ money at will. When rating agency Standard & Poor’s downgraded the US to AA+ in the wake of the GFC in 2011, panicky investors fled in troves to the treasury market, boosting the price of the downgraded securities.
Admittedly those were different times. Interest rates were much lower then, and it was assumed they would stay low for the foreseeable future. Some progressive economists even claimed the total amount of sovereign debt did not matter much, as interest payments would only be a small, easily affordable burden to the budget (Modern Monetary Theory).
Assaulted from all sides, Fitch stated: “The rating downgrade of the United States reflects the expected fiscal deterioration over the next three years, a high and growing general debt burden and the erosion of governance…over the last two decades [which] has manifested [sic] in repeated debt-limit-standoffs and last-minute resolutions.”
To make their point clear, Fitch also pointed to conversations with the US Treasury over the January 6, 2021 insurrection, which saw Trump supporters storming and thrashing the Congress building and threatening the lives of its members. To highlight the real, and visible fiscal problems of the United States did not come as much of a surprise to the financial community, and might have justified a downgrade much earlier, relevant, or not. The US federal debt is forecast to reach 118 per cent of GDP in the next couple of years. The fiscal deficit, the shortfall of tax income over government expenditure, has reached $US 1.4 trillion in the first three quarters of the current fiscal year – 170 per cent higher than the same period last year.
Interest expenditure has already risen to $US 1 trillion per annum, comprising three-quarters of all discretionary government spending, bar defence. This creates long-term problems. Private investment will be crowded out by lucrative government debt. Benefit cuts and higher taxes will have to be weighed against inflation-boosting profligacy. The ability to pay for the next financial crisis, the next pandemic, or the next war may be compromised. With major buyers of US debt – like Japan, China, and most importantly, the Federal Reserve – in retreat, and massive new debt issuance in the pipeline, creditors – the buyers of US securities – will raise the price for lending. This all does not weigh on the soundness of US debt though, or its digestibility.
It takes a single goofball congressman to suggest choosing to disavow foreign debt, but a lot of statesmanship to dismiss it
The critical element in Fitch’s reasoning was “erosion of governance”. What if the US, always capable of paying its debts, does not want to do so? The quoted “debt-standoff” when either the Democrats or – more notorious – the Republicans in Congress and the Senate – refuse in a dire game-of-chicken to raise the debt ceiling, is only one of the dysfunctionalities of US politics. As we speak, a single Republican congressman, Tommy Tuberville, is refusing to approve of promotions for top leaders and hundreds of officers of the US Armed Forces, making America’s defence capabilities fair game.
Republicans can threaten any fiscal expenditure, be it the war efforts in Ukraine, already approved social benefits, or statutory healthcare expenditure. They even discuss the possibility of choosing to disavow foreign debt. This sounds outlandish and unreal. But the US has not hesitated to disregard its own signature before, when it disclaimed the Iran Accord, or the Paris Agreement. With Putin’s war of aggression and the increasing rivalry with China, many conventions have fallen overboard. Tariffs are levied on friends and foes, foreign investment and investment abroad is eyed with suspicion, the SWIFT payment system is weaponised; Russian foreign currency assets are not only frozen but now designated to pay for reparation, and the US dollar is rendered largely useless for sanctioned countries. It is only a small step to do the full Putin and regularise debt payment bans for “unfriendly countries”.
We are not there yet, and I have no idea how repayment sanctions could be structured and legalised to ever become practical or unassailable at court. It is hard to pinpoint ultimate ownership of US securities, and neigh impossible to see who is selling on who’s behalf. But so was monitoring and implementing a price cap on Russian crude oil, so easy to circumvent and so ineffective in face of a plethora of willing buyers. The damage caused by creating what would be a dual-class ownership of treasuries would be huge. Yet it is thinkable. It takes a single goofball congressman to suggest it, but a lot of statesmanship to dismiss it.
The price of long-dated US bonds is rapidly falling these days, and yields therefore rising. This does certainly not reflect the new stain on the US debt status, nor its fiscal deterioration or the excessive supply of new debt issuance, now and in the years to come. It is not a reaction to Fitch’s argument of political dysfunction either. The possibility of extreme events is almost never priced in by markets: Nobody has a price for cataclysmic events, like China invading Taiwan, or Putin going nuclear; the US becoming ungovernable and its democracy breaking apart is one of them.
Rising yields on the long end of bonds and the gradual unwinding of the yield inversion, are the realisation of markets that the risk of outright recession has been postponed and Fed tightening is here to stay. Rate-cutting is not on the cards yet.
Andreas Weitzer is an independent journalist based in Malta.
The purpose of this column is to broaden readers’ general financial knowledge and it should not be interpreted as presenting investment advice, or advice on the buying and selling of financial products.
andreas.weitzer@timesofmalta.com