Investors should pay more attention to the American debt problem

Horizons article
July 4, 2023

A few weeks ago, on June 1, American politicians finally agreed to raise the debt ceiling of the United States government. Investors, who feared the lack of an agreement could trigger a crisis in the US government bonds market, were relieved.

It is important to see, however, that the problem of American debt has actually become bigger. After all, the June 1 agreement did nothing to reduce the high level of spending of the government. Historically, the only time in which the US has had a budget deficit as large as it is now, the country was either at war or in a financial crisis.

To balance the budget in the next decade, the government must take extremely drastic measures, like cutting all government-financed healthcare or pensions, the Congressional Budget Office has warned. To make matters worse, higher interest rates will create more problems by raising borrowing costs: if the rate on the 10-year US Treasury reaches 5%, the interest payments by the government will be as big as the entire COVID relief plan - every single year.

What is most worrying, however, is how deeply rooted the American debt problem actually is. Recent events show America has become too divided to come to agreements on how to reduce spending (which, to be fair, is also a problem in other countries).

Fitch, one of the three credit rating agencies, has warned that, in spite of the June 1 agreement, they could still choose to downgrade the credit rating of the US because they cannot see how government finances will improve. Indeed, this is similar to what happened in 2011. Back then, a few days after Washington agreed to raise the debt ceiling, Standard & Poor, another credit rating agency, chose to downgrade the US credit rating, triggering a wave of panic in the financial markets.

For investors, all of this points to a key insight. In fixed income (government bonds), institutional investors generally follow fixed income benchmarks and therefore automatically invest in the most indebted countries, like the US, because these countries have the largest weight in those benchmarks. Going forward, however, the key question is to what degree investors will simply continue to follow these benchmarks, or whether they will seek to protect themselves against the uncertainty around the American debt problem by looking (gradually) for alternative allocations.


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