Moody’s recent downgrade of the US sovereign credit rating (from AAA) sends a clear signal: the country’s fiscal situation is becoming untenable. While this downgrade doesn’t change the US’s overall credit rating – which was already split-rated AA+ – it now brings all three major credit rating agencies into alignment. S&P first downgraded the US from AAA to AA+ in 2011, followed by Fitch in August 2023. The loss of top-tier status didn’t rattle the bond market back then, but today’s environment is different.
What matters now is how the bond market views the fiscal position of the U.S. Moody’s announcement followed a week of mounting stress in the financial markets, during which the 10-year Treasury yield climbed as high as 4.55 per cent – even amid expectations of easier monetary policy. Bond investors are responding to the perception of rising risk in the American economy, including the prospects of tariff-induced inflation and rising budget deficits. The current budget deficit stands at roughly $2 trillion, with lawmakers expected to approve a significant, unfunded tax cut.
Since late last year, the bond market has been anticipating additional easing of monetary policy and a further normalization of the front end of the yield curve. At the same time, the market has been pricing in increased risk on the longer end. As we’ve noted, the term premium on the 10-year Treasury is an important indicator to watch. It turned positive last November and is now adding about 75 basis points to the 10-year yield.
Implications for Canada
For Canada, the implications are twofold. First, higher long-term US interest rates will limit the scope for lower 5-year (or longer) mortgage rates here. Second, with the government planning increased spending, it’s important to understand – and carefully assess – the risks posed by higher federal debts and deficits.
In the early 1990s, Canada’s credit rating came under pressure due to rising public debt and large budget deficits. By 1995, the country’s debt-to-GDP ratio was approaching 70 per cent. That same year, the Wall Street Journal labelled Canada an “honorary member of the Third World.” As a result, successive federal governments were forced to make difficult fiscal decisions.
Government spending was cut through expenditure reductions and the downloading of programs to other levels of government. In the early to mid-1990s, back-to-back governments of different political stripes — first the Progressive Conservatives and then the Liberals — began to reduce funding for social housing. A key turning point came when the federal government capped social housing funding at $2 billion per year and transferred responsibility – including funding – to CMHC. Because CMHC’s debt was not included in the federal government’s balance sheet, program spending continued but no longer appeared in official federal debt and deficit figures.
As the government advances its housing plans, it will be interesting to see whether the Finance Department reaches back into its old bag of accounting tricks and begins exploring off-balance sheet funding for some of its major housing finance initiatives. The Canada Mortgage Bond (CMB) program started out this way, as an off-balance sheet financing program with a targeted size of $50 billion. Could the proposed $25 billion in financing for prefabricated housing be next?
Independent Opinion
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