Moody’s changed the outlook to negative
On Friday after the market closed, Moody’s changed the outlook on US Government debt to negative from stable but also “affirmed the long-term issuer and senior unsecured ratings at Aaa”.
Moody’s states that the “key driver of the outlook change to negative” is the assessment that:
The “downside risks to the US’ fiscal strength have increased and may no longer be fully offset by the sovereign’s unique credit strengths. In the context of higher interest rates, without effective fiscal policy measures to reduce government spending or increase revenues, Moody’s expects that the US’ fiscal deficits will remain very large, significantly weakening debt affordability. Continued political polarization within US Congress raises the risk that successive governments will not be able to reach consensus on a fiscal plan to slow the decline in debt affordability.
Moody’s is essentially saying that the large US fiscal deficit has sharply lowered the US debt affordability in the context of higher interest rates, and that the US Government needs to either cut spending or increase taxes, or preferably both, to restore fiscal stability over medium term.
However, Moody’s also doubts that that’s even possible given the US political polarization. Thus, this action is likely the warning before the actual US debt rating downgrade. Note, other two major credit rating agencies (S&P and Fitch) already downgraded US debt from the Aaa risk-free status.
The reality is grim, both US political parties apparently just want to win the next election, which produces short-termism. To win an election, conservatives must promise tax cuts, but can’t cut spending, while the liberals must promise more spending, but can’t increase taxes. Both parties need a strong economy, so the compromise solution has been high fiscal spending and low taxes, and it worked well for both parties while in office. Add to this the supportive monetary policy, and you have a supercharged US economy. But underneath it all is the unsustainable deficit and rising inflation – and that’s what Moody’s is warning about.
The ultraconservatives and the shutdown
Moody’s change in US debt outlook to negative comes one week before the November 17th deadline to pass the government spending appropriations bills. If the 12 appropriations are not passed by the House and Senate and signed by the President by November 17th, the US Government will enter into a partial shutdown.
The probability of a compromise solution is likely zero percent, and the best outcome is another extension – a continuing resolution CR. The moderates from both parties are calling for a “clean CR”, but the House ultraconservatives are willing to pass the multistep or “laddered CR”, which is unlikely to pass the Senate.
It’s difficult to see where the compromise could be reached, the new House Speaker Johnson is unlikely to go for the bipartisan bill like the previous speaker McCarthy. The only area of compromise could be the realization that there is an active war in the Middle East and that the US government shutdown could be a national security issue. But still, a clear CR is unlikely to pass – so what miraculous compromise will be reached remains to be seen.
Moody’s predictions
The House ultraconservatives actually have views that are more consistent with the Moody’s warning – the US spending must be reduced. If not, these are the Moody’s predictions until 2033:
- The federal interest payments relative to revenue to rise to 26% in 2033 from 9.7% in 2022, and relative to GDP to 4.5% from 1.0%. More than a quarter of revenues for interest by 2033!?
- But here is the scary part, these projections assume that with the average annual 10-year Treasury yield will peak at around 4.5% in 2024 and settle at around 4%. What happens if the 10Y yield goes much higher than projected?
- The fiscal deficits of around 6% of GDP near term will rise to around 8% by 2033 due to higher interest payments and aging-related entitlement spending.
- The US federal government’s debt burden will increase to around 120% of GDP by 2033 from 96% in 2022, which will inflate the interest bill.
Obviously, these are scary predictions for the US fiscal situation, but could get even worse if the long-term rates continue to rise beyond 5%, which is actually very likely due to the unfolding trend of lower foreign demand for Treasures due to deglobalization.
Moody’s reasons to downgrade US debt
Moody’s assumes that the US economy will remain resilient, which could continue to growth the US fiscal revenue and partially slow the debt affordability decline. Second, Moody’s expects the Fed to continue to support the economy, despite the rising inflation, and ultimately believes that the Fed will be able to engineer a soft landing.
However, Moody’s lists the reasons for which the they could downgrade US debt:
The US rating would face downward pressure if Moody’s were to conclude that policymakers were unlikely to respond to the country’s growing fiscal challenges over the medium term, through measures to increase government revenue or structurally reduce spending to slow the deterioration in debt affordability”.
Under this scenario, a downgrade would reflect higher confidence that the deterioration in debt affordability and fiscal strength was likely to undermine the US’ economic strength and/or the role of the US dollar and Treasury bond market
A weakening of institutions and governance strength, such as through deterioration in monetary and macroeconomic policy effectiveness or the quality of legislative and judicial institutions, could also strain the rating.
Such an outcome would weigh on the sovereign credit profile, particularly if it were to reduce confidence that the US dollar and Treasury bond market will retain their unique and central roles in the global financial system, which currently bring considerable support to the rating.
Moody’s send a clear warning, the fiscal spending has to be reduced and taxes increased, with a medium-term policy in mind. Otherwise, the USD (UUP) could depreciate and long-term interest rates (TLT) could increase, which could cause a sharp economic downturn – and worsen the debt affordability.
Further, Moody’s warns that the monetary policy ineffectiveness could also threaten the USD global reserve currency status – which is really the ultimate threat.
Implications
Moody’s warning points to a very dire situation. It is very unlikely that the US short-termism would not change given the current US political dynamics. Nobody is really willing to address the deteriorating US fiscal situation, beyond getting the cheap political points. Thus, Moody’s US debt downgrade is likely forthcoming.
The primary implication is that the long-term US interest rates (TLT) are likely to continue to rise, despite the likely recession in 2024. In fact, the Fed Chair Powell questioned the safe haven status US Treasuries when he noted that the correlation between stocks (SPY) and bonds has broken.
The nightmare scenario is that the US enters a recession with still high inflation (stagflation) where the fiscal revenues decrease and: 1) the Fed is unable to lower interest rates due to inflation, and 2) the Government is unable to increase spending due to large deficit. The policy error in this situation could lead to hyperinflation and ultimately the dethroning of the US Dollar as a reserve currency.
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