Following the downgrade of the U.S. credit rating by Moody’s from Aaa to Aa1, we expect a rising risk premium across the Treasury curve as investors digest the implications of the downgrade and the direction of fiscal policy.
Yields increased all along the Treasury curve in overnight trading, with the 10-year breaching 4.5% and the 30-year moving above 5% before Monday’s opening.
The unusual intersection of trade and fiscal policy is creating the conditions for further financial volatility that could send yields higher, the dollar lower and equity prices on a wild ride.
It appears that fiscal policy is moving toward larger deficits, which will provide a fiscal impulse of just under 1% of GDP in the near term but would also add, according to the Committee for a Responsible Federal Budget, $2.9 trillion in government debt over a 10-year period and $3.3 trillion if made permanent.
The Joint Committee on Taxation has estimated it could cost as much as $3.8 trillion over the next decade.
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That would add $3.3 trillion to the national debt over the full 10-year window and $5.2 trillion if made permanent, which would add 1.8% and 1.9% to the budget in interest rate costs, respectively.
Interest costs under the current scenario are equal to 4.2% and 4.4% of GDP. It would result in an increase in debt as a percentage of GDP to 125% and 129% if made permanent.
In our estimation, the bond market is not buying it and risk is asymmetrically skewed toward higher interest rates at the long end of the Treasury curve.
Moreover, the more important risk is that investors will step up the pace of swapping out dollar-denominated assets for other safe havens, causing yields to rise along the entire Treasury curve.
