S&P Is Dead Wrong About U.S. Debt
This is a guest post from Jay Feuerstein, the Chief Investment Officer of 2100 Xenon Group.
On Monday, Standard & Poor’s heightened fears of a global debt crisis by cutting its outlook on America’s AAA debt rating to negative over the next two years. Already spooked by Europe’s debt crisis and China’s latest tightening, global financial markets plummeted on the news, leaving investors dumfounded at the prospect of an insolvent America.
In a statement, S&P said, “We believe there is a material risk that United States. policymakers might not reach an agreement on how to address medium and long-term budgetary challenges by 2013; if an agreement is not reached and meaningful implementation is not begun by then this would, in our view, render the U.S. fiscal profile meaningfully weaker than that of peer AAA sovereigns.” S&P went on to say the probability of a credit rating downgrade is 33 percent over the next two years—the highest such probability in history.
The facts in no way support this view. The bottom line is this:
Government debt has swelled in the past 23 years since the Savings and Loan crisis, which is the last government debt crisis, but interest rates are so low that the cost of carrying the current debt load is a fraction of what it once was.
What’s more, despite recent economic issues, current GDP is nearly triple what it was during the S&L crisis. In 1988, the average interest cost of a dollar of U.S. Treasury debt was a whopping 9 percent.
Today, it is a mere 2 percent.
Furthermore, today the Treasury has a more diversified portfolio of assets. Besides traditional bonds, the Treasury now issues Treasury Inflation Protected Securities (TIPS), which balance the interest rate risk of the United States. The interest rate on TIPS moves inversely to traditional debt securities so the Treasury can diversify borrowing risk and better manage its interest rate risk.
In actuality, interest expenditures have barely increased since the Savings and Loan crisis. According to data from the Treasury Department, interest expense as a percentage of GDP has been steadily declining since the last real estate crisis in 1988. That year, approximately 4.23% of GDP went to pay for interest expense. Today that number is closer to 2.8%.
This means the ability of the U.S. to service its debt has increased by nearly 60 percent over that time period. Calculated in 2005 dollars, the GDP in 1988 was $4.95 trillion and interest expense was $321.4 billion. Today, interest expense has increased by about $50 billion to $375 billion, but GDP has swelled to more than $13.2 trillion. This clearly demonstrates that the U.S. has a much better ability to pay its liabilities than it did in the past.
Meanwhile, demand for U.S. debt continues to be—surprisingly—strong.
Sovereign purchases of our debt have never been greater in both the raw dollar amount and by the percentage of assets held in other countries. And our currency remains the world’s currency of choice,.
Even despite its recent decline.
S&P criticizes the weakness of the U.S. balance sheet compared to other AAA-rated countries, but it fails to name which ones. Perhaps this is because there are none.
The Euro, for example, has been strong, yet five of its members have debt ratings barely above junk status. Italy, Spain, Greece, Ireland and Portugal are all heavily dependent upon bailouts.
The Chinese situation is also questionable. They are imposing wage and price controls to fight inflation, despite the utter failure of that policy in the U.S. during the Nixon administration. History tells us that once that policy ends, the Chinese economy will swoon along with the currency. Not only that, but the Chinese manipulate their interest rates, capping consumer savings rates at 2.75 percent while charging as high as 11% for consumer debt. That is not a recipe for a stable balance sheet and currency.
By putting the U.S. on negative watch, S&P is clearly trying to make up for its past sins. We all know that leading up to the global financial crisis, ratings agencies such as Moody’s and S&P issued troves of AAA ratings to structured debt products which ultimately turned out to be worthless.
S&P missed the mark then and is now trying to redeem itself by warning against another potential crisis. While this might be well-meaning, it is also irresponsible. To pronounce the U.S. insolvent is a very serious action that can damage the currency and scare away borrowers.
It can call the country into question on all fronts socially, politically and militarily. It ‘s not grounded in facts. To be honest, it’s slander.
Fortunately, U.S. stocks and bonds have rallied since their initial kneejerk reaction to the pronouncement. Despite being the victim of exceeding irresponsibility and outright wrongheadedness, the markets were not fooled.
Too bad the same cannot be said for S&P.
Xenon is a Chicago-based, systematic commodity trading advisor with expertise in the the global fixed income markets and central bank activity. The firm manages money for both institutional and retail investors, and is an affiliate of Old Mutual Asset Management. The firm invests in Treasury and interest rate futures.
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