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Recently, Moody’s downgraded US government debt from AAA to AA1, a move that sent ripples through the financial world. While the downgrade itself, a single notch on a 21-notch scale, might seem insignificant, the underlying reasons and the broader implications for investors are far more concerning. The team at Heresy Financial explains why this should matter to everyday investors.
Moody’s cited two primary reasons for the downgrade: the sharp rise in US federal debt due to persistent fiscal deficits and the increasing cost of servicing that debt as interest rates rise. In essence, the US government is borrowing more and more money, fueled by increased spending and, at times, lower tax revenues. This, coupled with rising interest rates, means that interest payments on the national debt are rapidly becoming the largest expense in the federal budget.
While a downgrade suggests a slightly higher risk of default, Heresy Financial argues this isn’t the most significant danger facing holders of US government debt. They point out that the US, as a sovereign nation with the power to print its own currency, can theoretically always print more money to repay its debts. Modern Monetary Theorists often highlight this as a key advantage.
However, the ability to print money doesn’t negate the risks. As Heresy Financial emphasizes, printing money devalues the existing currency. This is where the real danger lies: inflation.
Imagine a scenario where the government prints a billion dollars for every citizen. The immediate result would be hyperinflation, rendering the dollar practically worthless. While this extreme example is unlikely, the current situation involves a more gradual, yet still impactful, erosion of the dollar’s purchasing power through consistent money printing.
This inflation erodes the real return on investments, particularly in US Treasury bonds. Even with a nominally positive interest rate (like 4.5% on a 10-year Treasury), the real rate, adjusted for inflation, is often negative. This means that investors are actually losing purchasing power over time. In the best-case scenario, loaning money to the US government through bonds results in a slight loss. And as Moody’s pointed out, the risk of default just became slightly higher.
The problems extend beyond just US Treasury bonds. Bond market ETFs like Vanguard’s BND, which invest in corporate bonds, are also affected. While corporate bonds typically offer slightly higher interest rates to compensate for a higher risk of default, they are still vulnerable to the same inflationary pressures as Treasuries. As the national debt grows and the government continues to print money, the purchasing power of the dollars received as interest and principal is diminished.
The traditional 60/40 stock-bond portfolio, long considered a cornerstone of investment strategy, is losing its appeal. This strategy thrived during the 40-year bond bull market from 1980 to 2020, characterized by falling interest rates and consistent bond price appreciation. However, that era has ended.
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Heresy Financial believes we are entering a period more akin to 1940-1980, where governments resort to printing money to manage debt, leading to negative real interest rates. Furthermore, the diversification benefits once provided by bonds are dwindling. Stocks and bonds are increasingly correlated, meaning they tend to move in the same direction, negating the traditional hedge against market volatility.
In conclusion, the Moody’s downgrade isn’t just a minor technicality; it highlights the growing challenges facing investors in the fixed-income market. Inflation, fueled by government debt and money printing, is eroding the real returns on bonds, even those considered “safe” like US Treasuries. The traditional investment landscape is shifting, and investors need to re-evaluate their strategies in light of these evolving realities. The 60/40 portfolio may no longer be the reliable solution it once was.
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