Last week, Standard and Poor's released a statement suggesting that the United Kingdom's sovereign credit rating was being reviewed. The statement was made on expectations that the UK's debt would approach or even exceed 100% of its annual GDP during 2009. Scary. Traders the world over saw this as a sign to evaluate the credit ratings of other sovereign nations and the US was hit hard. US equities markets began to plummet and the dollar was beat to the ground. US Bond yields almost instantaneously jumped 30 basis points driving prices to the floor and sparking discussions of an impending debt downgrade. So is there any merit to the fear of a US debt downgrade? Or worse yet...gulp...even fears of a default?
"We're Out Of Money" said Barack Obama (go to second 0:29) on CSPAN last week and indeed "we" are. The President goes on to say (paraphrased) that we have a "short term problem" and a "long term problem". He suggests that our fiscal issues and the current economic crisis are short term issues while the looming crisis is Medicaid and Medicare. However, facts from Mr. Obama's administration tell a different story.
According to the United States Congressional Budget Office, if Barack Obama would have changed nothing after coming into office, by 2019, the US debt obligation would have amounted to 42% of annual GDP. How much is 42% of annual GDP? Roughly 5,991.13 Billion dollars, this (shockingly) is in-line with historic norms. However, the CBO goes on to say that after the past 6 months of spending, and the inclusion of Barack Obama's proposed budget, by 2019 the US will need roughly 82% of GDP to service its debt load.
Does this sound like it is a short term problem to you? Not that the US's health care issues are not problems, but this level of debt is more than just a short term thing. The amount that the US has borrowed from the world is simply staggering and is well beyond normal. This level of debt will take decades to pay back and will cost multiple generations a tremendous amount. So to the first question, is a US debt downgrade possible? Absolutely. In that case, if a downgrade is possible, what does it mean for America's outstanding obligations?
Quantitative Easing
Throughout the great recession the Federal Reserve, Treasury, and President's office have been spending money like it's going out of style. As illustrated above, in order to spend the US is borrowing money at an alarming rate. As it incurs more and more debt, naturally, it is required to pay interest on that borrowed money. Knowing this, the American government has been doing everything in its power to reduce interest obligations.
In December the Fed announced for the first time in 28 years that they would begin to actively buy T-Bonds in the open market (with money printed from the Treasury). They also made a similar announcement in March to purchase up to $300 Billion in "mixed duration" Treasury instruments. By purchasing long term T-Bonds (with treasury printed dollars) the government has been working to drive debt durations down. Why is lowering debt duration important? Low durations are required to ensure that overall borrowing costs remain as low as possible on any new debt issued. This is where quantitative easing comes into play.
Until recently the strategy of quantitative easing has been fairly successful (in relative terms; it can't work in the long term) as the world has flocked to United States debt as a safe haven investment. Evidence of this can be found in the fact that the average duration on all outstanding US debt is currently at about 4 years; the shortest in history. It can also be seen in US Treasury Yields which have been at their lowest levels in decades. The only problem with this exercise is that in order for it to continue to work, one of two things must eventually happen:
1. Spending has to come to a halt, tax receipts need to climb dramatically, and the US government needs to act in a fiscally responsible manner in order to properly service existing debt obligations.
Or...
2. Interest Rates have to stay low indefinitely so that debt service payments remain manageable.
If these two things are the only way that quantitative easing can continue, what will the result be for the bond markets?
Option 1
It does not appear that the government will take or can take option one in the short term. However, in the long term it is all but inevitable that this trail must be blazed. The only problem with the "stop spending and raise taxes" option is that the US's 8.9% (and rising at an alarming clip) unemployment, coupled with a lack of "real" economic gains, continues to erode the nations already shrinking tax base. Plain and simple, at some point, in order to stop deficit spending and properly service debt the US will need more cash in the treasury. The only way to get that cash is through increased tax revenue, fiscal responsibility, and sustainable long term interest rates on US obligations. As this is not currently happening its relationship to the bond markets is all but irrelevant at this time.
Option 2
This week the US Treasury will be selling or has sold $40 Billion in 2 year notes, $35 Billion in 5 year bonds, and $25 billion in 7 year bonds. This whopping one week total of $100 Billion in US debt is unusual, and also incredibly important. For starters, this week's auctions clearly show that the government is still foolishly pursuing quantitative easing. A quick look at the maturity of the debt offered is evidence of this enough; no maturity longer than 7 years. Additionally, according to the Wall Street Journal:
"Market participants noted investors, including foreign central banks, have cut long-dated Treasury holdings and parked cash in two-year notes and Treasury bills, a trend that may create a challenge for the U.S government at a time when it needs to sell a record amount of debt."
Thus, based on the happenings above, it should be increasingly clear that option #2, over the long term, is not sustainable. Today's debt auction results and the climb of the yield curve, across all mid to long term maturities, (note the trend since March when quantitative easing was announced) is an indication that the market won't allow nearly interest free US spending to continue indefinitely. This also begins to beg the question "What will the US do when its short term debt matures and needs to be refinanced? What will be the interest cost in 4 years at this spend rate? This is called rollover risk and I wonder how many are considering it.
Out of fears that loans may not get paid back, the market will demand more interest on its money when it is loaned to the US government. After this, the market will then try to reduce the duration of loans to the United States to the shortest possible period of time to reduce exposure risks. Then risks of inflation will also come into the picture as the market lends to the government. Each debt issuance will lead to more premiums being demanded to compensate for a loss of purchasing power in US dollars over the duration of the loan. All in all this will ultimately drive bond yields higher, drop bond prices continuously lower, and eventually dislocate the US debt markets.
Can The US Go Bust?
Does that mean the US can go bust then? It certainly does, but that is highly unlikely to happen. The US is not a developing country and it has the ability to print money to meet interest and principal obligations. At the risk of sounding arrogant, if the US were to go bust the world would go bust. I sincerely don't intend to deliver that from an American elitist point of view; I think I'm anything but. However, based on the size of the US economy alone, if there was a US default much of the global financial system would all but collapse.
Assuming the US does not collapse, will the printing of new money greatly devalue the US Dollar and increase inflation? Certainly, but this is not likely to happen in the near term. More deleveraging in the financial system is needed, and this event is unlikely while deflationary pressures remain strong. So, again, what does that mean for US debt? It means that while the Federal Reserve and Treasury continue pursuing quantitative easing, (option 2) the markets are likely to become increasingly dislocated. It means yields will continue to rise, prices will continue to fall, and debt service costs in the United States will become unmanageable. At this time, consumer borrowing rates will then also start to climb and will add further pressure to the US governments problems. (Did anyone see what mortgage rates did after yesterday's debt auction?). When debt service costs will finally grow to an unsustainable level is anyone's guess. However, if what is happening with treasury yield curves over the last 3 months is any indication, that time is coming soon.
