On August 1, Fitch Ratings downgraded U.S. government debt from AAA to AA+. Three decades ago, S&P did this. The question is why?
The short answer is that the U.S. government is on a deficit and debt path that cannot be sustained. Government debt will pass 100% of GDP in the next year or two. Amazingly, the deficit will increase during that period. I’ll explain this shortly. First, let’s look at Fitch’s main points.
Here’s Fitch’s summary:
Ratings Downgrade: The rating downgrade of the United States reflects the expected fiscal deterioration over the next three years, a high and growing general government debt burden, and the erosion of governance relative to ‘AA’ and ‘AAA’ rated peers over the last two decades that has manifested in repeated debt limit standoffs and last-minute resolutions.
If only they had stopped there. But, instead, there’s a long list:
- Erosion of Governance
- Rising General Government Deficits
- General Government Debt to Rise
- Medium-term Fiscal Challenges Unaddressed
- Exceptional Strengths Support Ratings
- Economy to Slip into Recession
- Fed Tightening
- ESG – Governance
Really, Fitch? “Medium-term Fiscal Challenges?” Ya think? And “Erosion of Governance?” That’s been an issue for at least three decades. To their credit, Fitch mentions that this has been an issue for the last 20 years. I suppose they had to add ESG to satisfy Black Rock and Fidelity.
What’s Really Going On
The U.S. government debt as of August 4, 2023 is $32,604,327,644,488.70. Of that, $6,845,039,787,664.48 is held by other government agencies. The argument is that this is debt the government owes to itself. Whether or not you believe that, $25,759,287,856,824.22 is held by the public. That group includes individuals, businesses, foreign governments, central banks, and probably other entities I don’t even know exist.
The implied debt-to-GDP ratios are
You read that correctly. The US will soon have a publicly held debt to GDP ratio of 100%. One way of looking at that is to assume the US government set the tax rate to 100%. In theory, the tax revenue for one year would pay off the government debt. In practice, of course, a 100% tax rate would collect zero revenue because there is no incentive to work, produce, or do much of anything.
The federal government spending blowout of the last two years affects the deficit. Again, from Fitch:
Rising General Government Deficits: We expect the general government (GG) deficit to rise to 6.3% of GDP in 2023, from 3.7% in 2022, reflecting cyclically weaker federal revenues, new spending initiatives and a higher interest burden. Additionally, state and local governments are expected to run an overall deficit of 0.6% of GDP this year after running a small surplus of 0.2% of GDP in 2022.
Fitch forecasts a GG deficit of 6.6% of GDP in 2024 and a further widening to 6.9% of GDP in 2025. The larger deficits will be driven by weak 2024 GDP growth, a higher interest burden and wider state and local government deficits of 1.2% of GDP in 2024-2025 (in line with the historical 20-year average).
Those are scary numbers. Fitch forecasts a publicly held debt to GDP ratio of 118.4% by 2025. And interest payments on the debt as a percentage of total government revenue will be 10% by 2025. By comparison, the median for AA rated debt is 2.8% and 1% for AAA. The US is on its way to a B rating.
What It All Means
The phrase everyone should dread is “failed Treasury auction.” That means some bonds in a scheduled financing will not be bought at any price. At which point, interest rates on that debt will soar.
There is an alternative. The Federal Reserve could buy the excess debt supply. That will increase the money supply, leading to inflation. Yes, I know, the Fed has some tricks they can use to soak up the additional money. Those tricks cannot be used for more than a couple of years.
A while back, I wrote about Herb Stein’s famous saying, “If it cannot go on forever, it will stop.” We do not know when the appetite of global markets for US securities will be sated. But I will say with absolute certainty that the current path is not sustainable for much longer. My guess is 10 years. But that’s a guess. We are in uncharted waters. Fasten your life jackets. A storm is coming.