In recent weeks, significant developments have emerged regarding the U.S. government’s financial status. Last month, Standard & Poor’s downgraded its long-term outlook on the federal government’s fiscal health from “stable” to “negative.” Surprisingly, in light of this news, the yields on 10-Year Treasury Notes have fell by 18 basis points.
While we might not fully grasp the complexities of global economics, we do have our own understanding of how these systems ideally function. A fundamental principle is that higher credit risk should correlate with higher potential returns.
Junk bonds, for example, are expected to yield higher returns compared to investment-grade debt. After all, who would willingly accept lower compensation for taking on greater risk?
Therefore, when a credit rating agency lowers its outlook on the fiscal health of the U.S. government to negative, we anticipate that yields on the 10-Year Treasury would increase, not decrease. If deficit spending continues unchecked, not only could we see a further downgrade in outlook, but the actual credit rating itself may also suffer.
Reflecting on the current fiscal situation and the challenges ahead, Standard & Poor’s reached a clear conclusion…
“Our negative outlook on our rating on the U.S. sovereign signals that we believe there is at least a one-in-three likelihood that we could lower our long-term rating on the U.S. within two years,” stated Standard & Poor’s credit analyst Nikola G. Swann on April 18. “The outlook reflects our view of the increased risk that the political negotiations over when and how to address both the medium- and long-term fiscal challenges will persist until at least after national elections in 2012.”
Work More, Receive Less
Unquestionably, the medium- and long-term fiscal concerns that Standard & Poor’s has identified are likely to endure. The enormous debt accumulated over the past 30 years creates a significant barrier that is unlikely to be overcome in the near future. It may take a generation or more of dedicated effort to settle the debts incurred by previous generations.
In the long run, the financial resources have already been exhausted. Future citizens will likely have to work harder for less than their predecessors did. However, before any recovery can even begin, it is crucial to halt further debt accumulation. The short-term fiscal issues the U.S. faces are immediate and require urgent action.
Treasury Secretary Timothy Geithner has issued a warning: if Congress does not raise the debt ceiling by May 16, the government will reach its $14.3 trillion credit limit. Notably, May 16 is just around the corner, and a Congressional agreement appears to be far from realization.
House Speaker John Boehner insists that any increase in the debt ceiling must be accompanied by spending cuts exceeding the amount of the increase. Meanwhile, Democrats seem to favor reducing the deficit by targeting the wealthier population. Fortunately for Congress, Geithner believes he can keep operations running until August 2 by reallocating funds. Between now and then, we can expect significant political drama.
“Global economies are closely monitoring the conflict between Republicans and Democrats over the U.S. debt and associated demands for spending cuts,” noted a recent Reuters report. “Failing to raise the debt ceiling could lead to the United States defaulting for the first time ever, resulting in higher interest rates that could negatively impact its fragile economic recovery.”
The Threat of Debt Default
The idea of a potential U.S. default may sound alarming. However, it’s important to clarify that the United States has faced such a situation nearly four decades ago.
On August 20, 1971, President Richard M. Nixon effectively closed the gold window, leading to a significant departure from the Bretton Woods system and leaving foreign governments unable to exchange their dollar reserves for gold as pledged. They were left holding an invaluable piece of paper instead.
“The dollar is our currency, but your problem,” Treasury Secretary John Connally remarked to several worried European Finance Ministers at that time.
Today, once again, fiscal mismanagement has placed the Treasury in a corner. This may lead to a default, which is already in progress.
Raising the debt limit may temporarily avert a conventional default—where the government cannot fulfill its obligations—but it will further the default that is already unfolding.
To articulate this concept, we turn to Bill Gross, the world’s largest bond fund manager. He asserts that any default will not occur in conventional ways, but rather through less visible mechanisms, including inflation, currency devaluation, and low to negative real interest rates that effectively ‘steal’ from savers.
To put it simply: Current Bank of America Certificates of Deposit are offering an annual percentage yield of just 0.35 percent.
Sincerely,
MN Gordon
for Economic Prism
