The recent decision by Fitch Ratings to strip the United States of its top credit rating had a seemingly muted impact on financial markets. However, beneath the surface, this event has triggered contemplation about the inherent, longer-term structural vulnerabilities that investors in government bonds might not yet fully comprehend.
While the immediate focus post the August 1 downgrade centered on US governance, Fitch also highlighted concerns such as higher interest rates amplifying debt service costs, an aging population, and escalating healthcare expenditures – challenges that resonate globally.
The aftermath of the downgrade underscored the urgency of addressing elevated debt levels amid a backdrop of anticipated high interest rates.
David Katimbo-Mugwanya, the head of fixed income at EdenTree Investment Management, emphasized the spotlight on debt sustainability due to this move to Reuters. The shift in focus, he noted, reflects a more permanent transformation rather than a cyclic occurrence.
S&P Global Ratings warned that without adequate cuts to age-related spending, median net government debt could rise to a staggering 101 percent of gross domestic product in advanced economies and an even higher 156% in emerging economies by 2060.
The core assumption that governments would prioritize servicing debt over fulfilling spending commitments is now being tested at these elevated debt levels. The study emphasized that policy measures are required to mitigate the burgeoning costs of an aging population.
Neglecting these measures could lead to a deterioration in creditworthiness, resulting in a significant portion of governments facing metrics indicative of junk credit ratings.
The European Union and the euro area, emphasizing public pensions and healthcare, also acknowledge the risks an aging demographic poses to debt sustainability.
While sustaining low financing costs with a debt-to-GDP ratio exceeding 260%, Japan attributes its situation to domestic ownership of government debt and accommodative monetary policy – a combination not easily replicable in other contexts.
Turning to the environmental domain, a recent study highlighted the potential impact of unchecked carbon emissions on debt servicing costs for nearly 60 nations within the coming decade.
Currently, despite witnessing some of the sharpest increases in borrowing costs in years, investors remain largely unworried about holding longer-term government debt.
Notably, the New York Fed estimates that longer-term US Treasuries still yield less than rolling over short-term debt, largely due to central bank government bond purchases. However, this trend is expected to reverse as central banks reverse these bond purchases and government financing needs escalate.
As long-dated bond yields reacted to a surge in US borrowing needs, the recent increase in yields indicates this potential shift.
Greater consideration of these longer-term risks should trigger a more thorough examination of government policies.
The role of policy becomes even more pronounced, particularly in the fiscal realm, as governments react to electoral promises and strive to achieve their objectives. Kshitij Sinha, a fund manager at Canada Life Asset Management, emphasized the importance of government actions in facing these challenges.
The ability of governments to mitigate relative debt levels through economic growth will be a critical factor. Climate change, paradoxically, presents both challenges and opportunities in this context.