US loss of AAA badge a reminder of ‘regime shift’ for government debt

US loss of AAA badge a reminder of ‘regime shift’ for government debt

The recent downgrade of the United States’ credit rating by Fitch serves as a reminder of the long-term risks associated with government debt. While financial markets did not react strongly to the downgrade, it highlights structural risks that investors in government bonds have yet to fully understand. These risks include higher interest rates driving up debt service costs, an aging population, and rising healthcare spending, which are challenges faced globally.

David Katimbo-Mugwanya, head of fixed income at EdenTree Investment Management, emphasized that the downgrade draws attention to elevated debt levels at a time when interest rates are expected to remain high. This brings debt sustainability back into focus and suggests a shift in the regime rather than a cyclical change.

Investors will eventually face pressures related to aging populations, climate change, and geopolitical tensions. Some investors, like Bill Ackman, a hedge fund manager, are betting on rising longer-term borrowing costs. However, many investors believe that these factors are too complex and their impact is too far in the future to influence their investment decisions.

Moritz Kraemer, former head of sovereign ratings at S&P Global, now chief economist at German lender LBBW, pointed out that rating agencies and investors are not adequately considering these long-term risks in a systemic way.

Research has shown that without cuts to age-related spending, government debt will rise significantly in advanced and emerging economies by 2060. The assumption that governments will prioritize servicing debt over spending promises has rarely been tested at such high debt levels. S&P Global Ratings expects policy steps to make aging-related costs more manageable. Failure to take these steps would lead to deteriorating creditworthiness and potential downgrades for many governments.

The European Union and the euro area have also identified costs related to aging as a key risk to debt sustainability, particularly in terms of public pensions and healthcare.

Japan, despite having one of the world’s oldest populations and a debt-to-GDP ratio exceeding 260%, has managed to keep financing costs low due to high domestic ownership of government debt and loose monetary policy. However, this may not be sustainable in the face of higher inflation.

On the environmental front, a recent study showed that failure to curb carbon emissions will increase debt-servicing costs for many nations within the next decade.

Gael Fichan, head of fixed income at Swiss private bank Syz Group, highlighted the challenge of relying solely on historical data for risk assessment when dealing with these long-term risks.

Currently, despite significant increases in borrowing costs, investors still perceive little risk in holding longer-term government debt. However, as central banks reduce their debt holdings and government financing needs rise, investors expect a reversal in this perception. The recent rise in long-dated bond yields in response to increased U.S. borrowing needs is evidence of this.

Kraemer believes it is unreasonable to rate shorter and longer-term government debt the same.

Greater focus on longer-term risks should lead to scrutiny of government policies. It will be crucial for governments to reduce relative debt levels by promoting economic growth, and climate change presents both a challenge and an opportunity in this regard.

With higher debt becoming an economic reality, very few governments still hold the coveted AAA rating. Kraemer suggests that a world without AAA sovereigns is possible, as seen in the corporate space where the number of AAA-rated U.S. companies has significantly decreased over time.

In conclusion, the Fitch downgrade serves as a reminder of the longer-term risks associated with government debt. These risks include factors such as higher interest rates, an aging population, rising healthcare costs, climate change, and geopolitical tensions. While some investors are betting on rising borrowing costs, many believe that these risks are too complex and distant to influence their investment decisions. It is important for rating agencies and investors to consider these risks in a systemic way. Governments must also address these risks through policy measures and focus on reducing debt levels while promoting economic growth. The possibility of a world without AAA sovereigns is not out of the question.

About News Team

Hi, I'm Alex Perez, an experienced writer with a focus on lifestyle and culture news. From food and fashion to travel and entertainment, I love exploring the latest trends and sharing my insights with readers. I also have a strong interest in world news and business, and enjoy covering breaking stories and events.

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