No More AAA - What the U.S. Debt Downgrade Means for Investors
24:54 Share

Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I'm your host, David Stein. Today is episode 525. It's titled, No More AAA, What the U.S. Debt Downgrade Means for Investors. Last Friday, the credit rating agency Moody's downgraded the U.S. government debt. It lowered it to AA1 from AAA.

Moody's has a 21-notch rating system. The U.S. was at the highest level. Now it's at its second highest level. In this episode, we'll explore what this downgrade means and whether we should be concerned as investors. Now, I remember when the S&P stripped the U.S. of its AAA rating in 2011. This was the first rating agency to do so. It happened August 5th.

2011, I was still working as an institutional asset manager. A few weeks earlier in July 2011, I had written and we had published our second quarter 2011 market commentary. At the time, Congress had refused to raise the United States legal borrowing limit, the debt ceiling, as it was working to negotiate spending cuts

in an attempt to reduce the budget deficit. The Congress had previously up to then raised the debt ceiling 16 times, but negotiations were bogged down. The U.S. hit its borrowing limit on May 16, 2011. Treasury Secretary Tim Geithner suspended contribution to federal retirement funds and did up

other measures basically to allow the government to still function without borrowing money. But by August 2nd, the U.S. would be forced to default on its obligations. In that commentary, I wrote, comparisons to Greece's debt situation are inevitable, but the differences between the U.S. and Greece could not be more stark. The U.S. issues its own fiat currency, and its debts are denominated in that currency.

That means it is physically impossible for the U.S. to default on its debt unless it chooses to do so willingly.

It can also print more currency to make interest payments and pay down debt. The U.S. does not issue debt or raise taxes in order to have money to spend. Under a fiat currency system, it spends electronically by debiting bank reserves and checking accounts. With the fiat currency, the only reason to issue debt or raise taxes is to manage the money supply so as to avoid inflation and not curtailment.

create too much money. Now, obviously, there are statutory reasons to raise taxes. There's accounting reasons. But because money is electronic, it's digits. It can be created out of thin air.

I continued, meanwhile, Greece, as a member of the European Union, does not control its own sovereign currency and consequently has no means of paying outstanding liabilities which are denominated in the euro unless it raises tax revenues or imposes massive sanctions.

spending cuts. And I pointed out that the bond market understands the difference between Greece and the U.S. And at the time, 2011, two-year bonds in Greece were yielding 32%, while the U.S. two-year yield was 0.4%. That was in 2011. Things have changed dramatically. And

Greece did not default on its debt, nor did the U.S., but the two-year Treasury bond yield for Greece right now is 2%. Its 10-year yield is 3.4%, yet its debt to GDP is 158%. We can compare that to the U.S. Its two-year bond yield is 4%, twice as high as Greece. The 10-year bond yield in the U.S. is 4.5%.

a percent higher than Greece. But the U.S.'s debt to GDP is only 100 percent, so significantly less than Greece, which should cause us to pause and realize that the level of debt, the national debt in the U.S. can go much higher without causing a financial crisis.

Now, what changed in Greece and Europe to where Greece's interest rates were no longer double digits? Well, in July 2012, Mario Draghi, president of the European Central Bank, gave a speech. The key line in the speech was, with our mandate, the ECB is ready to do whatever it takes to preserve the

the euro. And believe me, it will be enough. What Draghi was referring to was the ability of the European Central Bank to create money out of thin air and buy government bonds issued by Greece, if it choose to, to support their debt market, the bond market of Italy. That speech laid the foundation for the outright monetary transactions of

programs that allowed the ECB to buy government bonds. It calmed financial markets. And at this point, European yields are less than the U.S.

In 2011, Congress did not force a U.S. default. The debt ceiling was raised August 2, 2011. And three days later, S&P lowered the sovereign credit rating for the U.S. S&P wrote, the downgrade reflects our opinion that

that the fiscal consolidation plan that Congress and the administration recently agreed to back in 2011 falls short of what, in our view, would be necessary to stabilize the government's medium-term debt dynamics. More broadly, the downgrade reflects our view that the effectiveness, stability, and predictability of American policy and political institutions have weakened at a time when

of ongoing fiscal and economic challenges to a degree more than we envisioned when we assigned a negative outlook to the rating earlier that April. So credit rating was lowered. Bond yields actually went down after that announcement. And the same for the subsequent announcement in August 2023, when Fitch downgraded U.S. credit rating from AAA to AA+. I didn't do an episode on

on money for the rest of us at the time. I talked about it in PLUS episode 443 for our premium members, and not a whole lot of changed with the Fitch downgrade in 2023. U.S. continues to run a large budget deficit. The debt to GDP continues to grow. Interest rates are higher, but not out of control. We did a three-part national debt series a year ago in the finale of

of that series, episode 479, I quoted Federal Reserve Chair Powell speaking on 60 Minutes. He said, in the long run, the U.S. federal government is on an unsustainable fiscal path. What that means is that the national debt as a percent of the economy is continuing to grow to where it could spiral out of control. We'll look at how in a minute. Powell continues, so it's unsustainable. I don't think that's at

at all controversial. I think we need to know that we have to get back on a sustainable fiscal path. And I think you're going to start to hear now from people in the elected branches who can make that happen. It's time we get back to that focus, have what he said were adult conversations. So that leads us to last week when Moody's was the last major credit rating agency to strip the U.S. of its AAA rating.

In its press release, it said, successive U.S. administrations and Congress have failed to agree on measures to reverse the trend of large annual fiscal deficits and growing interest costs. We do not believe that material multi-year reductions in mandatory spending and deficits will result from current fiscal proposals under consideration. Congress is looking to pass a spending and tax bill. The current House bill is...

is projected to increase the budget deficit by another $3 trillion by 2034 as it locks in existing tax cuts and spending on defense and securing the border is more than reductions in other areas of government.

In reading Moody's report, there wasn't a lot of detail. They expect that budget flexibility will remain limited as mandatory spending on social programs and spending on interest expense will consume 78% of total spending by 2035, up from 73% in 2024. They believe

By 2035, the U.S. will be running a budget deficit to GDP of 9%, up from 6.4% in 2024, much of that due to higher interest rate cost. But they didn't provide their assumptions of what they believe the average interest rate will be.

Moody's expects the federal debt burden will go to 134% of GDP by 2035, compared to 98% in 2024. Note that 134% is lower than the debt burden of Greece, which is at close to 160%, and similar to Italy's current national debt to GDP of 135%.

Tenured Treasury bond yields in Italy right now are 3.6%, a percent lower than the U.S. Now, the Congressional Budget Office also does a long-term budget outlook. They released their most recent one in March. Their numbers are not as dire as Moody's. They believe by 2035, the federal budget deficit to GDP will be 6.1%.

Compared to 9% assumption for Moody's, the Congressional Budget Office believes that the debt to GDP as held by the public will be 118% in 2035 versus 134% for Moody's. Before we continue, let me pause and share some words from this week's sponsors.

Money for the rest of us is built on two important principles, good information and trust. When I was an institutional investment advisor, these two principles were essential in creating and maintaining strong client relationships. And these same principles are foundational to our investment research and strategy tool for advisors, Asset Camp. Asset Camp helps advisors earn client trust with clear data-driven insights.

AssetCamp's stock and bond index valuation tools, expected returns modeling, and monthly investment strategy reports better equip you to quickly help your clients understand market movements and how you're protecting their future. These are the tools I wish I had when managing billions of dollars for institutions, and they're the tools that power my own investing and our membership community, Money for the Rest of Us Plus.

Get a free seven-day trial of AssetCamp to read our latest comprehensive monthly investment strategy report. Access a shorter market commentary you can share with your clients and test drive all of AssetCamp's simple, powerful tools to see how they can improve your research and modeling. You can access everything for free for seven days at AssetCamp.com. That's A-S-S-E-T-C-A-M-P.com.

The first thing that contributes to an increase of the overall debt level to GDP, and what we're measuring is not the absolute size of the debt, but the relative size of the national debt compared to the assets, which is the private sector economy, the dynamism of the economy.

of the American economy. What is the value of what is being produced relative to the debt level? And what drives the value of the debt divided by GDP is clearly each year's budget deficit. So if the budget deficit to GDP is 6.1% this year, then the national debt will increase

will increase by 6.1% if the economy doesn't grow. So that's the second factor. If the economy is growing at the same rate as the national debt, given we're at 100% national debt to GDP, then that level won't increase. So if the deficit to GDP is 6.1% and

nominal GDP growth is 6.1%, which it won't be, then the debt won't grow. The problem is the deficit does need to be lowered in order to make it sustainable. The other component that contributes to the growing size of the national debt is the average interest.

interest rate. And so if the average interest rate is lower than the growth in the economy by GDP, that helps hold down the national debt. It's called Jensen's inequality. We went into great detail on that in episode 479. But we want to look at that because we want to understand the underlying dynamics, something we can actually monitor.

What is that budget deficit to GDP? We would prefer it to be closer to 4%, especially during a time when the economy is growing, ideally 3% to GDP. Now, the Congressional Budget Office, in looking at their assumptions going out to 2035, they're expecting nominal GDP growth of a

around 3.8% to 4.1%, with an average interest cost on all federal debt of 3.6%. That would actually be sustainable to where the debt to GDP would be growing, but it would be growing slowly and wouldn't necessarily lead to a crisis.

The problem with these long-term assumptions and what we have seen over the past two decades is how a financial crisis, the great financial crisis, the global pandemic, that is what ballooned the federal budget deficit to almost double digits or more and led to big jump in the national debt. And so these long-term economic

economic forecast, don't assume another major financial crisis, which could blow the debt dynamics completely apart.

In 2055, based on their baseline assumptions, CBO expects U.S. national publicly held debt to GDP to be 156 percent, lower than what Greece is currently. And we've pointed out that Greece has lower interest rates. Italy has lower interest rates. Now, those interest rates are determined by the policy rate. So the European Central Bank, its current policy rate, which ends up being the rate on short-term debt, is 2.25 percent.

The Federal Reserve's is a range of 4.25 to 4.5 percent. So double that. And that's why short term interest rates are much higher here than in the European Union, including Greece in Italy. Now, with Moody's debt downgrade, we have seen longer term interest rates in

in the U.S., specifically the 30-year Treasury bond yield, it rose to over 5%, 5.08% for the first time since 2023. I went back and looked at a history of the 30-year Treasury bond yield. Most of the time for the last 20 to 30 years, it's been less than 5%, but it reached 5.35% in 2007, 5.5%

in 2002. And then if we go back to the late 90s, it was over 6.5%. In fact, for most of the 1990s, 30-year treasury bond yields were over 6%. And yet we've not had a national debt default. The debt has been managed. It was smaller at the time. If average interest rates creep up to where that average interest rate cost is higher than the nominal GDP growth,

So higher than, let's say, 4% or 5% across all the debt that's concerning. Now, that's one reason the U.S. and other countries, they issue a lot of shorter-term debt. One, that's where the demand is, and those short-term rates are closely impacted by...

whatever rate, the policy rate of the central bank. Now, if we look at inflation and expected inflation, that will also impact longer-term interest rates. There are three main drivers of interest rates. One is the policy rate by the central bank. And that's

And that includes expectations for future policy rates by the central bank. Second factor would be inflation expectations. And the third factor is any additional compensations investors demand to hold government debt. And that's called inflation.

the term premium. And now that third element has been increasing in the U.S. It's up to about a half a percent right now. It has been over 2% in the past. And that's another thing we can monitor when we monitor the national debt situation. What is the term premium investors are demanding to hold the national debt? And if it's getting higher, that shows the bond market is worried. Why

One of the unknowns with the U.S. currently is the tariffs and how that will impact in

inflation. There's a scuffle going on between President Trump and Walmart right now. Last week, Walmart's chief executive Doug McMillan said on an investor call, we will do our best to keep our prices as low as possible. But given the magnitude of the tariffs, even at the reduced levels announced this week, we aren't able to absorb all the pressure.

President Trump responded on social media, Walmart stopped trying to blame tariffs as the reason for raising prices throughout the chain. Walmart made billions of dollars last year, far more than expected. Between Walmart and China, they should, as it said, eat the tariffs, not charge valuables.

valued customers anything. I'll be watching, and so will your customers. Walmart then issued a press release that said, we have always worked to keep our prices as low as possible, and we won't stop. We'll keep prices as low as we can for as long as we can, given the reality of small retail margins. If businesses in the U.S. eat the tariffs, they're

Their profit margins will suffer and they'll likely potentially see profits fall, which could impact their stock price and the overall U.S. stock market. We don't know, but there is this ongoing game as to how much will the tariffs be? How will that impact businesses?

How much of that will be passed on to customers because the tariff is an additional tax and retail margins are thin. So that's something to be seen, but it also impacts the national debt situation because it will impact the growth in the economy and it'll impact the

the level of budget deficit because the tariffs do raise tax revenue, which could reduce the budget deficit, but could also lead to slower economic growth, which could lead to more expenditures on unemployment. It's a complex, evolving situation. So we'll see. But when it comes to U.S. national debt, there are things we can monitor. And we're not in crisis mode yet, despite

the downgrade by the credit rating agencies. We can look at the deficit to GDP and is it shrinking or is it growing? We can look at the average interest rate on the debt.

And the underlying contributors to that, including the term premium. And we can look at overall economic growth and see how the debt situation evolves. We have the projections. And yeah, the debt is higher, but it's not as high as some of the developed markets expected.

And the U.S. has some benefits. It is the U.S. dollar is the reserve currency that gives the U.S. the ability to borrow at lower rates than it might otherwise because so much trade is denominated in the U.S. dollars. And those dollars can be recirculated and invested in Treasury bonds. Now, potentially that will happen less in the future as U.S. seeks to reduce its trade deficit, as we have talked about in R&D.

our tariff episodes. Now, one of the countries I've not mentioned yet that often comes up when we talk about unsustainable national debt, that country is Japan. If we look at its gross national debt, the total value of the debt divided by the economy, it's around 200%. And

That's the highest in the world. But Japan is different in this regard. If we actually look at the publicly held debt as a percent of GDP, it's less than the U.S. at 78% compared to 100% to the U.S. Much of the rising debt balance in Japan is due to Social Security payments, asset

As Japan's population ages, it has run a continued budget deficit. But if we back out Social Security, Japan's actually run a budget surplus. And here's the other thing when it comes to Japan and Social Security, they have a huge reserve.

And what Japan did, in addition to making adjustments to Social Security, such as curbing medical expenditures, adjusting public pension contributions and payouts, things to make, put it on more sustainable footing, instead of drawing down the reserve like the U.S. government has done with its Social Security trust fund, Japan borrowed more

more money and then took those reserve assets and invested it in riskier assets, including the stock market. And so the debt balance ballooned even higher, but the assets grew by an even larger amount. Japan's Social Security Reserve

reserves were 36% of GDP in 1997, but they grew to 60% of GDP in 2023. And so we can't just look at the debt and say, boy, that gross debt amount is high relative to the economy. We have to understand the underlying debt dynamics. And Japan borrowed more money and then invested it, and they earned a positive carry. Their return on their assets

their assets is greater than the debt cost. And that has allowed that debt balance to be manageable and the reserves to grow. Moody's in their press release said the outlook for the U.S. was stable. They downgraded it, but their credit outlook is stable. They pointed out the U.S. dollar status as the world's dominant reserve currency. Its ability to roll over debt balances to borrow at attractive interest rate, albeit

higher interest rates now, but it pointed out probably the thing that concerns me the most. They write, underpinning the rating is our assumption that the U.S.'s institutions and governance will not materially weaken, even if they are tested at times. In particular, we assume that the long-standing checks and balances between the three branches of government and

and respect for the rule of law will remain broadly unchanged. There's been a lot going on with the Trump administration in its

its first hundred plus days with numerous executive orders, many of which have been challenged, making their way through the court system. But to me, the line in the sand, if there's going to be a constitutional crisis, is how the Trump administration reacts when the Supreme Court makes a ruling that is so clear cut that there really isn't any reasonable argument for it to be ignored.

and the administration ignores it. That could have tremendous political and financial consequences.

U.S. citizens, including myself, will have to decide how to react to that. Now, I don't know if we'll get there. I hope we don't get there. I don't want us to get there. But that is a way politics could impact certainly the national dead, but more important, our way of life. So we'll keep monitoring as things evolve. Right now, I'm not overly concerned with

with the level of the national debt, but we also know what we should look for to be concerned. What's the average interest rate? How fast is the economy growing? What is the deficit to GDP? What is the term premium? And what are overall interest rates, which have risen, but we've had over 5% interest rates before for 30-year treasury bonds. They're back below 5% today. We'll keep monitoring and see how things evolve. That's episode 525. Thanks for listening.

You may be missing some of the best money for the rest of us content. Our weekly Insider's Guide email newsletter goes beyond what we cover in our podcast episodes and helps elevate your investment journey with information that works best in written and visual formats. With the Insider's Guide, you can discover investing and economic insight provided only to our newsletter subscribers. Unlock greater investing confidence with high value snippets from our premium products plus

plus membership and asset cap. Further connect with the Money for the Rest of Us team and community. And when you sign up, we'll also send you our exclusive investing checklist to help you invest with more confidence right away. You'll also get our introductory email series on eight essential investment principles that if followed can make you a better investor. We'll also share our recommendations for podcast episodes, articles, and books.

The Insider's Guide is the best next step to get the most out of your investment journey. If you're not on the list, go to moneyfortherestofus.com and subscribe right there on the homepage. Everything I've shared with you in this episode has been for general education. I've not considered your specific risk situation. I've not provided investment advice. This is simply general education on money, investing in the economy. Have a great week.