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The USA Debt Situation Analysis

Introduction

There have been increased concerns over the future of US debt ratings considering the shaky financial situations prevailing in the country and the world economy at large. Several credit ratings are downgrading the US debt ratings and one independent credit rating agency claims that in the next two years, the US credit rating is going to be a “C” (from triple A) (CNBC 1). Standard and poor have also downgraded their credit ratings to negative (from stable) (Reuters 2). The US government debt is quickly coming close to the 14.3 trillion mark, and there is increased concern that, this is going to cause a significant downgrade of the government’s treasury bonds. Compared to other countries, the US has been rated 33 out of 47 in the global credit ratings and independent credit rating companies are currently equating the US debt ratio to be similar to France and Japan which have also received a ‘C’ credit rating (CNBC 3). However, other countries such as Thailand and China have received positive credit ratings (‘A’). ’Moreover, the debt to Gross Domestic Product ratio (GDP) is also close to 100% and this has exacerbated concerns regarding the future of the US’s treasury bonds performance. Though the worsening US debt situation is likely to cause the Treasury bond interest rate to fall to 2%, this study establishes that, the bond market does not anticipate such an eventuality. To affirm this point, this study incorporates relevant theories and includes the involvement of treasury and investor expectations in coming up with the ultimate interest rate projections.

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Justifications

The fact that congress has set a ceiling for the US debt causes a lot of jitters in the bond market because it affects how treasury bonds will be auctioned and ultimately how the interest rates will perform. However, treasury has had a long history of increasing the debt ceiling if there is adequate concern to do so (Politi 4). In a nutshell, the current circumstance of the US debt situation is a justifiable ground for the reevaluation of the US debt ceiling. In this regard, the bond market is not anticipating a significant downgrade of the US treasury bonds because besides treasury’s intervention in the situation, the institution has been on track regarding its borrowing schedule because in the following three months, starting May 2011, treasury has been able to acquire 72 billion dollars in projected funding (Politi 4). This stable performance has been observed despite the fact that, the debt ceiling situation is uncertain at this point.

With regards to this debate, economists at RBS (cited in Politi 4) note that, “Debt managers were likely to maintain the status quo, since cutting coupon auction sizes now – though warranted – could add confusion to an already noisy debate” (Politi 4). From this understanding, the coupon auction sizes are likely to stay stable for a long time because if any cuts are implemented, it is likely to be assumed that, treasury is avoiding the political debate of raising the debt ceiling. Treasury has also warned that, if the debt schedule is changed, the bond market could be severally affected, especially if the debate about raising the US debt ceiling continues.

The bond market does not also anticipate a decrease of the Treasury bond interest rates because investors across the globe still perceive the US debt as a viable investment (Politi 5). This fact is supported by recent developments in the global financial sector, which have seen the treasury register a trading performance of 3.2% (Politi 5). Moreover, the August deadline for default of the US debt can be significantly changed by treasury because it has the power to do so. This default ceiling has a direct impact on the performance of Treasury bonds and chances that the government is going to sit back and let interest rates drop below two percent and very low.

This observation is supported by the expectations theory which explains that future maturities are usually perfect substitutes of each other and future interest rates of government treasury rates are normally subject to the expectations of investors in future trading. As evidenced in earlier sections of this study, we see that the US Treasury bond is performing well and still, investors trust that, the performance of the US Treasury bond is going to be good. With such information at hand, the expectations theory is able to construct a yield curve to determine the future interest rates of the yield bond; assuming that the government (treasury is not going to intervene in the entire situation).

Through the expectations theory, we can deduce what the future interest rate will be, based on the expectations of investors in the current year. To determine the future interest rate, we take the year’s interest rate and compound it with the interest rate to be evidenced in the following year. This analogy goes hand in hand with the theory that, interest rates usually move together but the greatest shortcoming of this method is the fact that, future interest rates are difficult to determine (beyond the two years).

From this analysis, we can see that, investor expectations play a crucial role in the determination of future interest rates and assuming that treasury is not going to intervene in the US debt situation; it will be difficult for the bond market to assume interest rates as low as 2%. However, realistically, treasury is bound to intervene in the situation and this will result to a stabilization of the bond market. Though Standard and Poor have rated the US debt situation from a positive to negative, this can be assumed to be a short term observation because the ratings have not included treasury’s involvement in the situation. A rating of negative is therefore not bound to withstand for long periods because the US Treasury establishes that:

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“Treasury will restrict the use of negative input yields for securities used in deriving interest rates for the Treasury nominal Constant Maturity Treasury series (CMTs). Any CMT input points with negative yields will be reset to zero percent prior to use as inputs in the CMT derivation. This decision is consistent with Treasury not accepting negative yields in Treasury nominal security auctions” (7).

Conclusion

The determination of the future of treasury’s interest rate is highly subject to treasury’s involvement in the US debt situation. If the current situation is likely to persist for long periods, future interest rates will probably go below 2%, but according to the evidences registered in this study, the bond market is not likely to expect such low interest rates because investor confidence in the trade of US security is still strong and treasury is bound to intervene in the situation anyway. Treasury’s involvement in the situation is guaranteed because its past record shows a consistent trend of intervention in such circumstances. Moreover, from the future expectations theory, we can see that, it is highly unlikely for the bond market to expect future interest rates of 2% in the coming 12 months (if there is a positive expectation of investments returns in the US bond market). Collectively, these factors indicate that, the bond market does not expect an interest rate of 2% in the coming years.

Works Cited

CNBC. US Debt Rating Should Be ‘C’: Independent Agency. 2011. Web.

Politi, James. Treasury in Debt Ceiling Warning On US Bonds. 2011. Web.

Reuters. Text: S&P Revises United States Outlook to Negative. 2011. Web.

US Treasury. Daily Treasury Yield Curve Rates. 2011. Web.

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