US debt gets downgraded
Fitch Ratings, a rating agency that rates the creditworthiness of both companies and countries, downgraded the rating on US government debt from the highest rating of AAA to the second highest rating of AA+. They cited expected fiscal deterioration, erosion of governance, and the repeated debt limit political standoffs as some of their reasons.
- Bond rating agencies are not generally known for their prescience, having lost some credibility after the financial crisis.
- That said, the US does face the most challenging fiscal situation in history
- The US national debt has been growing steadily and outpacing our economic growth
- Currently, we owe $31.5 trillion
- Debt to GDP, a measure of our outstanding debt to the output of our economy, has climbed to over 120% from over 50% in 2000
- It has particularly accelerated since 2010, with a huge boost during the pandemic when the federal government borrowed over $3 trillion to stimulate the economy (this is separate from what was done by the Federal Reserve)
- The US treasury just announced they would need to borrow $1 trillion just in the third quarter of this year
- As long as the US Dollar remains the reserve currency of the world, the total amount of debt outstanding matters less
- This is complicated today by many emerging economies actively trying to move away from the USD into alternatives
Long-end yields rise
The long end of the US treasury curve (10 yr - 30 yr US govt bonds) rallied on the back of the downgrade. The downstream effects of long-end yields rising are multiple folds. The current interest rate (yield) on bonds is a baseline for interest on other debt, including mortgages, credit cards, and corporations that borrow money. Increasing interest rates reduce the propensity and ability to borrow. This hurts the economy.
- While yields were already rising, the Bank of Japan interest rate hike last week and this week’s downgrade catalyzed another ratchet higher
- Yields on the 10yr and 30 yr bonds reached the prior recent highs achieved in late October of last year
- In addition to having a negative impact on the real economy, higher rates are also bad for stocks as a headwind for valuations
- They also have a negative impact on holders of existing bonds; as the value of bonds falls, the more rates rise; hence the bank failures we witnessed earlier in the year
- The long end of the US treasury market will be important to monitor over the coming months
Labor market remains strong
This week we learned US non-farm payrolls increased by 187,000, slightly less than the 200,000 expected. The unemployment rate ticked down to 3.5%, and hourly wages increased by 0.4% for the month and 4.4% year over year. Earlier in the week, we received a blow-out ADP employment report, coming in at 324,000, topping expectations of 174,000.
- The strong labor market is indicative of a strong economy
- The problem, however, is wage pressure, which continues to persist
- Anecdotally, the UAW (United Auto-Workers Union) just this week asked for a 40% wage increase for some of its workers over the next four years
- Wage pressure is a thorn in the side of inflation, and hence means higher interest rates