Horseman of the economic apocalypse: Friday’s US debt forecast has shocked traders and bankers
As the closing bell rang on Friday, triggering the usual exodus of bankers and traders to their watering holes, a bombshell dropped: Moody’s Investors Service has shifted its outlook on the Government of the United States from stable to negative, citing heightened risks to fiscal strength.
This adjustment comes amid the looming threat of a government shutdown, with funding secured until November 17, and newly elected House Speaker Mike Johnson revealing a Republican government funding plan.
Against the backdrop of higher interest rates, Moody’s is emphasizing the need for effective fiscal policy measures to address large fiscal deficits, warning that, without such measures, debt affordability could significantly weaken. The agency attributes part of the risk to ongoing political polarization in Congress, raising concerns about reaching a consensus on a fiscal plan. Despite the negative outlook, Moody’s expects the US to maintain its exceptional economic strength, suggesting that positive growth surprises could slow the deterioration in debt affordability.
As the government faces potential funding challenges and political gridlock, Moody’s decision aligns with a trend seen in August, when Fitch downgraded the US long-term foreign currency issuer default rating. Moody’s is now the sole major credit company maintaining a top rating on the US, with S&P Global Ratings having stripped the country of its top score in 2011.
The move triggers discussions about the implications for investors and market participants. While the shift by Moody’s signals concerns about fiscal risk, experts note that the downgrade’s impact on banks and institutional investors appears limited, given the established use of US Treasuries as collateral and regulatory assets. The downgrade raises questions about alternatives to Treasuries and prompts consideration of the evolving market dynamics in response to these credit-rating changes.
Despite the criticism and disagreements, the shift by Moody’s serves as a reminder of the rising fiscal risks and challenges facing the United States, contributing to a complex economic landscape as the nation navigates potential disruptions and uncertainties. Following the announcement, Ten-year Treasury note futures experienced a decline, hitting fresh session lows, while the yield on US ten-year Treasuries rebounded to 4.65%, matching the earlier session’s highs.
Monday market outlook: Anticipating a bearish trend amidst rising concerns over US Treasury downgrade
As the markets prepare to open on Monday, a bearish trend is anticipated. It’s crucial to recognize that government deficit spending doesn’t mimic household finances; instead, it generates money in the private sector. While government interest payments are on the rise, the US isn’t facing a binary choice between servicing interest and investing in the real economy. The downgrade of US Treasuries introduces concerns about its impact on various market participants. Despite the rating adjustment, the fundamental attributes of US Treasuries, such as high rating, liquidity, and a robust repo market, remain intact.
Commercial banks, major Treasuries buyers, use them for regulatory purposes, collateral, and for hedging interest-rate risk, with the Basel regulatory framework mitigating the impact of the downgrade on capital requirements. In essence, for banks, this downgrade is inconsequential. Pension funds, significant purchasers of Treasuries, utilize them for long-duration matching and collateral, suggesting minimal material impact. FX reserve managers, while factoring in ratings, often group AAA-AA rated governments together, mitigating the downgrade’s significance.
The downgrade prompts reflection on alternatives to Treasuries, including consideration of Japan’s government bonds (cue my sarcastic chuckle) and Europe’s bond market. In the realm of market dynamics, it’s crucial to focus on the rate of change, avoiding overinterpretation and emphasizing extrapolation.
This approach aligns with how the market responds to evolving situations. US Deputy Treasury Secretary Wally Adeyemo criticized the downgrade by Moody’s, asserting that the US maintains its AAA rating, emphasizing the strength of the American economy and the global prominence of Treasury securities as safe and liquid assets.
This double whammy will send shockwaves through corporate debt, hitting the reset button at higher rates. In 2023, a cool $500 billion of existing corporate debt is up for refinancing, followed by a hefty $800 billion in 2024 and a jaw-dropping $1 trillion in 2025. Brace yourselves – consumers are about to feel the pinch.
The unemployment rate, already on the upswing, plays its part in this unfolding economic drama. Couple that with an inverted yield curve, and the dominoes are falling in a way that spells one thing: a looming, deep recession. The only thing preventing an immediate crash? You guessed it–lavish government spending. It’s a temporary band-aid, but it’s steering the US into a hazardous spiral.
Janet Yellen’s initially enigmatic statement takes on a clear meaning upon closer inspection, as she subtly suggested hours before Friday’s closing bell that China might reduce its Treasury holdings. Traders blissfully brushed aside this veiled caution, reveling in a 400-point surge in the Dow.
Unlike the usual practice of rating agencies providing advance notice of impending downgrades to governments, Yellen’s discreet briefing on the upcoming downgrade served as a subtle message to China. Now it becomes apparent that the individuals selling Treasuries on Friday afternoon, during a period of overwhelmingly positive market sentiment, were likely responding to this behind-the-scenes information.
With Yellen pushing for a hefty issuance of US Treasuries to fund government spending and not one but two ongoing wars (an extra $700 billion this quarter and a whopping $800 billion in Q1 2024), brace for the inevitable: rising yields and a nosedive in bond prices. Adding to the drama, China and Japan, harboring serious doubts about Uncle Sam’s debt-paying prowess, might decide to ditch their US debt holdings.
Can the US really afford two wars, especially with an extensive global network of 800 military bases? The exorbitant spending isn’t exactly bolstering the real economy; it’s merely a distraction from the genuine issues festering within the US. Welcome to the tumultuous world of economic brinkmanship.
