14 OCT, 2023
Clément Inbona, Fund Manager in La Financière de l’Echiquier.
Rate rises from the Fed and the European Central Bank have put an end to the enchanted interlude of practically zero interest rates for countries with a sound credit rating. A new era of higher interest rates is beginning, which will require tighter fiscal policies or the debt burden will gradually increase over time as debt is refinanced.
During the sluggish month of August, the agency Fitch Ratings caused consternation and controversy with its downgrade of the US from the highest credit rating of AAA. Yet two months on, it looks as if it may have been right: for the 22nd time in less than 50 years, the US is again flirting with the shutdown of government activities due to the failure of Congress to agree on a budget. This was one of the main arguments in the rating agency’s decision, which was specifically motivated by “the erosion of governance over the last two decades that has manifested in repeated debt limit standoffs and last-minute resolutions.”
Former Treasury Secretary Larry Summers called this decision “bizarre” and “inept”, but it appears logical and clear-sighted today. Logical, because the US political system is unusual in that negotiations on the budget and the debt ceiling very often serve as an opportunity to hold the government to ransom, in the absence of a majority in Congress. And clear-sighted, as despite stronger growth than expected in the first half of 2023, the deficit could reach 6% this year and in the coming two years, which is hardly a sustainable fiscal trajectory over the long term. In addition, interest rates – already high in August – have continued to rise in recent weeks, with US 10-year yields reaching 4.65%, increasing the cost of US debt a little further.
A shutdown would mean a two-fold risk for the US economy. Firstly, the country could see another downgrade to its credit profile, this time by Moody’s – the only agency that still rates the US on the highest rating for issuers. The second risk relates to the Fed, which would be operating in the dark in the event of a shutdown, as without funding, government agencies will cease to produce official statistics on inflation and other indicators such as the labor market. The Fed itself says that it is more data-dependent than ever, so how will it be able to make enlightened decisions in the dark?
In theory, a country has an infinite lifespan, in contrast to other economic agents. Thus the main determinant of the cost of indebtedness – the interest rate – is not the level of debt but the extent to which its fiscal trajectory is sustainable. This expected trajectory must not tend towards infinity or this could result in prohibitive interest rates and accelerate this headlong rush. Whether in the US or on the other side of the Atlantic, countries must acclimatize to this new environment of positive interest rates and deal with a debt burden that is heavier and more costly than ever, or risk the wrath of rating agencies and markets.