Memorial Day: Downgraded, and still spending

America marked Memorial Day with a fresh downgrade to Aa1 from Moody's and with Congress pushing ahead on another fiscal package worth several trillion dollars that would widen federal deficits further. The two facts sit awkwardly together. Washington appears to have given up on protecting its credit rating in favour of spending more, more or less indefinitely.

The sequence was hard to miss. Moody's removed the country's last top-grade rating on 16 May, citing deficits and rising interest costs. Six days later the House passed the administration's tax bill by 215 votes to 214, extending the tax cuts of 2017 and adding new breaks without paying for them.

A downgrade, then a tax cut

Elsewhere, in emerging and developed markets alike, a sovereign downgrade usually prompts quick belt-tightening. Governments cut spending and look for new revenue to win back creditors' confidence. Washington shrugged off the loss of its last top-grade rating. Lawmakers moved ahead with multi-trillion-dollar extensions of tax cuts without matching spending cuts or reforms to entitlements.

The bill's savings come mostly from tighter eligibility for Medicaid and food assistance, much of it phased in after the tax cuts take effect. The tax cuts themselves start at once. That ordering means the deficit widens first and the offsets arrive later, if a future Congress does not repeal them before they bite. Budget analysts have learned to treat savings scheduled for the back end of a ten-year window with scepticism, because they often never materialise.

America can behave differently because it borrows in its own currency and issues the asset the rest of the world uses as collateral and reserves. That privilege is real. It lowers the cost of borrowing without abolishing it, and it depends on investors continuing to believe that Congress will eventually pay attention to the sums.

What London learned in 2022

Britain offers the nearest recent warning. In September 2022 a new government announced large unfunded tax cuts, gilt yields jumped, pension funds using leveraged hedging strategies were forced to sell, and the Bank of England had to step in to buy long-dated bonds. The prime minister was gone within weeks. America's market is far deeper and its currency far more important, so a collapse on that scale is unlikely. The episode still shows how quickly bond investors can turn from tolerance to revolt once they doubt a government's plans.

Clinton's lesson from 1993

America has its own history of bond-market discipline. The Clinton administration took office in 1993 with plans for new spending and ended up putting deficit reduction first, in large part because advisers feared that long-term interest rates would choke the recovery. The budget deal that year raised taxes on high earners and trimmed spending, and long yields fell. A year later the bond rout of 1994, when the Fed began raising rates and yields jumped worldwide, showed how quickly investors could reverse course. The lesson Washington absorbed then was that the bond market sets limits a government ignores at its peril. The present Congress appears to have forgotten it.

Bond buyers may not wait for ever

The politicians are betting that the bond market will absorb unlimited new debt without charging more for it. That bet looks shaky. Net interest payments already exceed one trillion dollars a year, so every rise in borrowing costs moves more money away from productive use and into servicing debt.

The federal government already spends more on interest than on defence. Investors have started to ask for more. A poorly received auction of 20-year bonds last week pushed the 30-year yield above 5 per cent, and mortgage rates are close to 7 per cent. Those costs fall on households and companies well beyond Washington: home buyers, small businesses that borrow at floating rates, and states and cities whose own bonds are priced off Treasuries.

Who pays the higher yield

The burden of a higher term premium falls unevenly. First-time home buyers face mortgage rates that have barely moved despite the Fed's cuts last autumn, because mortgages are priced off long-term yields rather than the policy rate. Companies that need to refinance debt issued cheaply during the pandemic will pay more, and those with weaker credit will pay most. Savers and pension funds buying long bonds gain higher income, and foreign holders of Treasuries are paid more to take on a risk they now have more reason to notice.

The Treasury itself is exposed through the structure of its debt. It has leaned heavily on short-term bills in recent years, which means rising rates reach the budget within months. Every percentage point on the average cost of servicing a debt of more than $36 trillion eventually adds hundreds of billions of dollars a year to spending, before a single new programme is funded.

The case for calm

The counterargument deserves a hearing. Japan has run government debt worth more than twice its GDP for years without a buyers' strike, and supporters of the bill argue that faster growth and tariff revenue will narrow the gap. Japan's debt is held overwhelmingly at home, however, much of it by its own central bank, while America relies on foreign buyers and on a Federal Reserve that is still shrinking its bond holdings, though more slowly since April. Tariff revenue, meanwhile, depends on trade deals that are being rewritten from week to week.

Even Japan's model looks less secure than it did. A weak auction of 20-year Japanese government bonds last week sent yields on the country's longest bonds to record highs, as the Bank of Japan steps back from buying and domestic insurers show less appetite. If the most patient bond market in the world is starting to demand more, the assumption that American debt can grow without limit at a stable price looks weaker still.

The signals to watch are the changes the Senate makes to the bill, the budget office's formal cost estimate, demand at the next auctions of ten- and 30-year debt and any sign that foreign official holders are trimming their Treasuries. America goes into the summer of 2025 widening its structural deficit as if nothing had happened, and if politicians will not impose discipline, bond investors will probably do it for them through higher long-term yields. The first to pay will be home buyers and indebted companies, and the bill is likely to arrive in the form of 30-year yields that stay above 5 per cent for longer than Washington expects.