Denial Is Not River in Africa on US Debt

America is in denial over its budget deficit and needs to get with the austerity program, according to HSBC.

Tim Graham | The Image Bank | Getty Images

"The Brits are doing it. So are theGreeks, the Irish and the Spaniards. Even the Germans are doing it. But until now Uncle Sam has demonstrably failed to get with the program," said Philip Poole, global head of marco and investment strategy at HSBC in London in a research note following S&P's decision to lower its outlook on US debt.

"S&P’s warning is the culmination of more than 10 years of US fiscal laxity from a combination of tax cuts and spending increases, aggravated by the impact of deep recession which further cut revenues and increased spending. According to the OECD, in gross terms US general government debt has increased by 70 percent since 2000," Poole said.

Poole, like many, believes an ageing populationrepresents a disturbing structural component to the longer-term challenge of reining in the deficit.

"Ageing will increase dependency ratios, pushing up the cost of entitlement programs and eroding the tax base as the proportion of workers falls. And this will happen quite quickly. The ratio of the population over retirement age to those of working age should increase by 5 percentage points in the next ten years," he said.

With no easy solutions on the horizon, there is clearly a long-term risk to US borrowing costs if nothing is done to get on top of the deficit which, in Polle's view, could see interest payments on servicing the federal debt hit 20 percent of federal revenues by the end of the decade.

How to Trade Soaring Debt

Following losses for equities and a flight of capital to safe haven assets like the yen , Poole is warning the S&P downgrade could be the catalyst for sending investors "back into risk off territory for a while."

"This development has the potential to unnerve foreign holders of US dollars. And there are lots of them," he said.

"With roughly 50 percent of marketable treasury securities held abroad, the dollar will likely be vulnerable to negative developments on the debt front", said Poole.

The problems in Europe, where talk of Greek debt restructuring is dominating debt markets, mean the euro is hardly a strong play on dollar weakness, he said. Gold, other precious metals and the Swiss franc are likely to be the beneficiaries, according to according to Poole.

Get on With It

With the duration on the US debt burden shortening in recent years as the federal government issued shorter term bonds, Poole warned that action is needed on the revenue or expenditure front fast.

"The maturity structure of government debt has been shortening, in turn raising the vulnerability to increases in interest rates because they will have a more immediate effect on debt servicing costs. But there are no easy solutions," Poole said.

But with Democrats unwilling to cede ground on entitlements and the Republicans unwilling to accept higher taxes, the path to fiscal balance is going to be rocky to say the least.

"The US recovery is not strong enough to deal with the withdrawal of both monetary and fiscal stimulus. For this and other reasons, we believe, it seems highly unlikely that the Fed will allow its balance sheet to shrink when QE2 (a second round of quantitative easing) expires in June. In our view, it will reinvest maturing mortgage debt into treasuries, locking in the liquidity that has flooded financial markets for some time to come," said Poole.