One agency’s downgrading of U.S. government creditworthiness highlights the potentially dangerous mix of high debt levels and rising interest rates. The phenomenon is hardly unique to the U.S.

In Focus - IOU

Fitch Ratings downgraded its assessment of the U.S. Government’s creditworthiness last week to AA+ from AAA. Not only did this move markets, it sparked some broader reflection about the U.S. debt situation.
There are at least two broad reasons for concern, each cited by Fitch.

First, there is the question of whether the U.S. is on an affordable debt path. Second, there is the issue Fitch labeled “governance” – whether current political processes seem functional enough to ensure payment on U.S. debt. While some prominent commentators emphasized this latter point, agreeing that a dysfunctional U.S. budget process justified the downgrade, we’re going to focus here on affordability of debt.

Just as individuals might have affordability “rules of thumb,” like spending no more than 30% of gross income on housing costs, there have been notional redlines for affordable government debt. As a round number, 100% debt to GDP is often put forward as a threshold for concern. When the Euro Area was established, the Maastricht Criteria required that government debt to GDP should not exceed 60%.

Getting beyond rules of thumb, there are a couple of factors that play a critical role in determining just how worrisome a debt level might be.

First, there’s GDP growth: if a country is experiencing very rapid growth, other things equal, that increases its ability to pay down debt in the future. Second, there are interest rates. If governments can borrow very cheaply, then large debt burdens are less worrisome.
Both factors point to increasing concern. In the IMF’s latest World Economic Outlook, it forecast overall growth in advanced economies to slow from 2.7% in 2022 to 1.5% in 2023 to 1.4% in 2024.

Even more striking have been increases in interest rates as governments try to fight surges in inflation. In the U.S., the upper limit of the Fed Funds rate went from 0.25% in March of last year to 5.5% as of July 26th.
The effect of this on government debt affordability is not immediate. Some government borrowing is very short term, but some has longer maturity, which means the rates are locked in until the government needs to refinance. Depending on the measure, the average maturity of U.S. government debt is roughly in the 5-6 year range.

This means that the effect of interest rate hikes on debt affordability will depend heavily on whether rates stay ‘higher for longer.’ To illustrate the relative magnitudes, the Congressional Budget Office projected in February that the 2023 U.S. federal deficit would be 5.3% of GDP, well above its 1973-2022 average of 3.6%. A five percentage point increase in borrowing costs would dramatically increase the deficit, given that U.S. debt to GDP was just under 100% in 2022 (using a more limited measure than the chart).

The chart shows that the U.S. is not alone in this problem. For all the countries shown except Germany, debt has increased significantly in recent decades. This makes countries vulnerable to an interest rate shock. Rates can also rise if investors lose confidence in the ability to pay and start charging a risk premium.

To assess the extent of that risk, they turn to ratings agencies, which is why it’s noteworthy when Fitch says it’s time to worry.

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Economic Developments

German real retail sales fell by 0.8% from May to June, marking the first decline since March. Retail sales in June were 1.6% below the level of June 2022, and retail sales for the first half of 2023 were 4.5% lower year-to-date, driven by a 5.8% decrease in food sales.

Q2 Euro area real GDP was estimated to be up 0.3% from Q1 and 0.6% above the same period in 2022. Ireland saw the highest GDP growth of 3.3% quarter-on-quarter and 2.8% year-on-year, while Sweden saw the biggest declines of 1.5% quarter-on-quarter and 2.4% year-on-year.

Euro area headline inflation slowed from an annualized rate of 5.5% in June to 5.3% in July. Core inflation, which strips out energy and food, was unchanged at 5.5% and now higher than headline inflation for the first time since February 2021, due to falling energy prices. Industrial goods inflation eased from 5.5% in June to 5.0% in July.

Euro area unemployment stayed at its record low of 6.4% for a third straight month. The two countries with the highest unemployment rates, Spain and Greece, both saw decreases from May to June, with Spain’s unemployment falling from 11.9% to 11.7% and Greece from 11.3% to 11.1%. Italy’s unemployment rate declined from 7.5% in May to 7.4% in June, down from 8.1% during the same period in 2022. June unemployment in France was unchanged from May at 7.1%, but still lower than its reading of 7.5% in June 2022.

U.S. overall unemployment ticked down from 3.6% in June to 3.5% in July, and there were 201k net new jobs in July. The ratio of employment to prime age population, which counts people in the 25-54 age group whether or not they are in the labor force, was unchanged at 80.9%, the highest reading since 2001.

U.S. job quits decreased from 2.6% in May to 2.4% in June, down from its reading of 2.7% from June 2022, suggesting a decline in worker confidence. The US job openings rate at the end of June was unchanged from May at 5.8%. While still higher than pre-pandemic levels, job openings were down by 0.9 percentage points from June 2022. Hires decreased from 4.0% in May to 3.8% in June.

Last week’s trade numbers showed autos continuing to be a consistent bright spot.

• Korea exports fell 16.5% year-on-year in July, the tenth consecutive decline. The decrease was driven by a 33.6% contraction in semiconductor shipments, although that was offset by a 15% increase in autos exports. Exports to the US were 8.1% below the level of the same period last year.

• German exports were up 0.1% month-on-month in June but down 1.9% from June 2022. An increase of 1.8% in goods exports to the Euro area was offset by a fall of 1.1% in exports to non-EU countries. An increase of 11.7% month-on-month in autos exports was offset by a -12.6% decrease in chemical product exports.

• Mexican auto exports rose by 31.2% year-on-year in July, the highest reading for this month historically, and the eighth straight month of year-on-year increases.

Political Developments

The BoE raised its Bank Rate 25bps to 5.25% last week, the 14th consecutive hike and bringing the UK’s key lending rate to the highest level since early 2008. The BoE noted that while annualized headline inflation fell from 8.7% in May to 7.9% in June, and it is expected to further slow to around 5% by the end of 2023, inflation is still well above the BoE’s 2% target.

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