With the recent chatter about the U.S. debt ceiling, the possibility of a default, and a credit ratings downgrade for the U.S., it’s easy to want to tune out the noise. Many people have the misconception that the whole situation doesn’t affect the average American; the world of high finance is so far removed from their world as to not have an impact on their way of life. Nothing could be further from the truth. Let’s take a look at how government bonds tie all the way from Wall Street to Main Street.
When the government needs to borrow money, it cannot resource a local bank branch for a loan. To borrow money, our government sells bonds to investors. These investors are mostly foreign central banks and large investment institutions. The investors buy the bonds which gives money to the government. The government pays the investor back their original investment, plus interest, over time. The interest is based on both the market conditions at the time and the creditworthiness of the government (loan rates are determined by the borrower’s credit score).
In the case of the U.S., the government’s credit rating is AAA (pronounced “triple-A”) which is the highest rating possible. For this reason, the U.S. government pays astonishingly low interest rates. At the time of this writing, the interest rate on a 10-year U.S. treasury bond is 3.03%. The high U.S. credit rating is currently under review by many of the credit ratings agencies. Even without a government default, many agencies are considering downgrading the U.S. credit rating simply because our government’s current spending path is completely unsustainable. If the U.S. credit rating is downgraded, then the U.S. will pay higher interest rates to attract investors to purchase their bonds.
The U.S. bond interest rate forms a foundation for all other interest rates. In other words, the higher the interest rate on U.S. bonds, the higher the interest rate will be for all lines of credit. This is called a direct correlation. The U.S. will pay higher interest in order to get investors to buy their bonds; therefore, U.S. citizens will see their loan rates go up. For example, the average 30-year fixed mortgage rate is typically, but not always, about 1.7% above what the government pays to borrow money. If the government pays a higher interest rate on U.S. bonds, then mortgage rates and other loan rates will increase.
This trickle-down effect could be seen throughout our economy. From the homeowner looking for a mortgage, to the small business owner looking to expand, a shopper looking for a new television, or even the farmer who needs a loan to get through the growing season, credit is the oil that lubricates our economy. Additionally, if the U.S. credit rating is downgraded, we could soon be paying higher prices for all purchases. It won’t matter how high an individual’s credit score is or how many bills he or she has paid on time, that person will still be subject to the rising tide of interest rates. A rising tide lifts all boats and this tide may be coming as we speak.
By Robert Davis, APMEX Account Manager
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