Robert Newman
The Senior Columnist, Rick Newman
Tuesday, August 15, 2023 at 10:10 PM GMT+5:30 minus six minutes read
The 2023 debt ceiling impasse has been resolved. However, the results are not.
Every debt limit confrontation may seem to follow a similar pattern, with things returning to normal when the pointless drama is gone.
The main conflict: Congress must increase the borrowing limit every few years since it is a legal requirement and federal indebtedness is increasing. Republicans demand expenditure reductions as a condition of permitting the government to borrow additional money, assuming they have the votes. There is passionate discussion about a potential US default on some of its commitments, along with fierce haggling. Financial markets become a little uneasy as a result.
The markets then calm down when a last-minute agreement materialises to prevent a catastrophe.
The 2023 debt saga proceeded as usual, with one exception: Things haven’t stabilised yet. Markets now view US Treasury assets as riskier than they did before to the agreement to expand the borrowing limit in June. This raises the cost of borrowing for the government, as well as for corporations and private citizens.
According to new study by David Kotok, chief investment officer of investment firm Cumberland Advisors, increased interest rates brought on just by Congressional budget antics could increase borrowing costs in the United States by roughly $1 trillion over the next ten years. Even while that is a sizable price tag, it is probable that the expenses will be shared widely across the economy in ways that will let the criminals in Congress avoid punishment.
Kotok examines the price of credit-default swaps on US Treasury securities to determine whether borrowing costs across the US economy have increased. A CDS, or credit-default swap, is comparable to an insurance plan for bonds. The risk that the bond issuer may go out of business and stop paying interest or principal can occasionally be covered by the bond holder. Other investors provide CDSs that cover losses at rates set by the market.
As Congress played chicken with the country’s creditworthiness earlier this year, as was to be expected, the cost of insurance against a US default increased. In order to pay for all of the government’s obligations, the US government had to shuffle money around after reaching its borrowing limit in January 2023. Up until June, according to Treasury estimates, it could continue doing that without defaulting on some payments.
According to Bloomberg data, the cost of insuring a 10-year Treasury bond was around 35 basis points before Treasury reached the borrowing limit in January. That amounts to 0.35% of the bond’s face value annually, paid as an insurance premium.
The price of the insurance increased as the June deadline approached, rising as much as 62 basis points. The cost of a CDS decreased as Congress reached an agreement to postpone raising the debt ceiling until 2025, as was to be expected. However, it did not decline to pre-crisis levels. Rather, it finally landed at about 41 basis points. Following a one-notch downgrading of US debt by rating agency Fitch on August 1, it then increased to roughly 48 basis points.
As the cost of insurance against their default rises, so do interest rates on Treasury bonds. Therefore, US interest rates are currently around 10 basis points higher than they would be if Congress had just increased the borrowing limit gradually, without any risk of default.
Although one-tenth of one percent may not seem like much, when applied to the total amount of public and private debt in the US, it adds up.
Kotok calculates that a one basis point increase in the rate at which the US must borrow results in an annual increase in federal borrowing expenses of $2.7 billion. The annual sum of additional borrowing expenses is $27 billion when multiplied by a factor of 10. The sum comes to $270 billion when extrapolated out over a ten-year period, but compounding might make it closer to $300 billion.
That $300 billion is a taxpaying obligation. The budget agreement, according to Republicans in control of the House of Representatives who wanted expenditure cuts before lifting the borrowing limit, will slash deficits by $1.3 trillion over the next ten years, including $240 billion less in interest payments on US debt. However, that does not account for the potential $300 billion increase in borrowing costs caused by the market’s increased perception of the riskiness of US debt. Therefore, using up all of those savings has a bigger default risk.
The Republican forecasts are also surprisingly optimistic.
The GOP’s expectation of $1.3 trillion in savings is at the high range of probable results, according to the Penn Wharton Budget Model, with the bottom end being $234 billion — excluding $300 billion in higher borrowing costs. In that case, the entire budget agreement would result in zero savings and end up costing taxpayers close to $70 billion.
Mortgage rates and many other consumer and commercial loans are measured against the 10-year Treasury bond, which fluctuates in direct proportion to it. Therefore, a 10 basis point increase in the 10-year will result in a corresponding increase in most other rates. There is about $43 trillion in company, private, state, and local debt in addition to the $27 trillion in government debt owed by the United States. According to Kotok, a 10-basis point increase in borrowing costs for all of that debt will cost nearly $1 trillion over the course of the following ten years.
Since most people won’t notice, they won’t go door-to-door in Congress demanding improved budget management. Even some seasoned investors won’t take into consideration this ever increasing risk of a US default because the CDS market is opaque and complicated. But they’ll still pay.
The carelessness of Congress about the borrowing cap is still ongoing. A new self-destructive budget dispute is inevitable in January 2025 because the debt ceiling has been suspended. The US credit rating was lowered by Fitch on August 1 for the following reasons: “expected fiscal deterioration over the next three years,” “erosion of governance,” and “repeated debt limit standoffs and last-minute resolutions.” Fitch might not have downgraded if there was a way to know the 2023 standoff was the last one.
But there is every reason to believe that another round of chicken will soon follow.