Message from bond market: US financing needs can roil equity markets

The yield on the 30-year US (United States) government bond on Monday briefly crossed the psychological 5 per cent mark. Financial markets were reacting to Moody’s Ratings downgrade of the US government debt from Aaa to Aa1. The other two large rating agencies, S&P Global and Fitch Ratings, have already downgraded the US. Thus, for the first time in over 100 years, the world’s largest and most liquid debt market doesn’t have a triple-A rating. While this will not lead to an immediate collapse in the US government bond market, investors’ confidence would take a hit and would perhaps get reflected in both the US and global markets over time. The reason for the downgrade is consistently rising US government debt and increasing interest costs. 

As Moody’s explained in its note, US federal debt has risen because of a sustained higher fiscal deficit. While spending has increased, tax cuts have reduced revenue. Without adjustment in revenue and spending, the government’s flexibility will be further limited. Mandatory spending, including interest payments, is projected to increase to about 78 per cent of the total by 2035, as against 73 per cent in 2024. If the 2017 tax cuts are extended, which is what the administration intends to do, it will add about $4 trillion to the primary federal deficit over the next decade. The federal deficit is projected to increase to about 9 per cent of gross domestic product (GDP) by 2035, compared to 6.4 per cent in 2024. The federal debt stock is also expected to increase to about 134 per cent of GDP, compared to 98 per cent in 2024. 

  A sustainably higher fiscal deficit in the US will have implications for both the US economy and the rest of the world. It is worth noting that the higher borrowing cost in the US is not a consequence of a higher fiscal deficit alone. The Donald Trump administration is in favour of higher tariffs, which it believes will help bring jobs in manufacturing back to the US. Although the administration is open to signing trade agreements with partners, including China, which would lower tariffs from the initially announced levels, it is safe to assume that the average tariff rate will remain significantly higher than it was when Mr Trump took office. This will inevitably push up US consumer prices, which will not allow the Federal Reserve to reduce policy interest rates as previously projected. A higher borrowing cost will affect consumer and investment demand in the US, resulting in lower growth. Further, structurally higher borrowing requirements of the US government will absorb a larger share of savings, both within the US economy and elsewhere, thereby affecting global capital flows. Despite the ratings downgrade, the US, with its inherent strengths, will continue to attract funds from around the world, at least for the foreseeable future. Thus, higher financing requirements and higher yields in the US will potentially tighten global financial conditions.

  As an analysis in this newspaper has shown, the spread between the US 10-year government bond yield and Nifty earnings yield has turned negative for foreign investors. Therefore, theoretically, for a foreign investor, it makes more sense to put money in US government bonds than Indian stocks. The yield difference between US and Indian government bonds has also narrowed. It is expected to decline further as the Reserve Bank of India is likely to cut the policy rate due to favourable inflation outcomes. Thus, the US fiscal and trade policies can significantly affect capital flows. Although India is expected to run a modest current-account deficit in the current year, pressure on capital flows can induce significant volatility in the currency market.