Source: Bloomberg. As of August 2023.
While there are clear near-term risks stemming from the downgrade, including rising yields and a potential sell off in equities and the dollar, we do not anticipate a lasting impact to U.S. financial markets. Investors are unlikely to cut their exposure to Treasuries, given the resiliency of the economy and the dominant role of the dollar and Treasury market in the global financial system. Investment guidelines were also revised in 2011 following S&P’s downgrade to eliminate specific ratings and just reference U.S. Treasuries, reducing the risk that institutional investors may be forced to sell their holdings. Further, bank capital rules are no longer ratings based, thus U.S. Treasuries will continue to carry a 0% risk weighting despite the downgrade. In our view, Fitch’s downgrade serves more to highlight the nation’s underlying issues of fiscal sustainability and the potential future consequences if the country does not take steps to address its rising debt burden.
Key rating drivers
When giving its rationale for the downgrade, Fitch cited “the expected fiscal deterioration over the next three years, a high and growing general government debt burden, and the erosion of governance relative to AA and AAA rated peers over the last two decades that has manifested in repeated debt limit standoffs and last-minute resolutions.” Fitch’s move gave further credence to S&P’s downgrade in 2011, which was driven by similar concerns about the country’s fiscal outlook. Since then, the federal debt has grown from around $15 trillion to $32 trillion in 2023 and is now on track to hit $50 trillion by the end of the decade. The Congressional Budget Office (CBO) predicts that federal debt as a percentage of gross domestic product (GDP) will climb to 132% over the next 10 years from 95% today.2
Fitch had initially placed the U.S. rating on “negative watch” in May, a reflection of growing unease around the current debt ceiling deadlock and default risk. The bipartisan decision to suspend the debt limit until January 2025 and cut federal spending by $1.5 trillion over the next decade did little to ease its fears. Fitch noted that the U.S. has made little progress in its efforts to reduce the surging costs of Social Security and Medicare, both of which are politically sensitive topics. The new credit rating leaves the U.S. on par with Austria and Finland but below Switzerland and Germany.3
While Fitch’s downgrade has drawn some criticism over the timing, initial market reaction indicates that it’s unlikely to derail confidence in the U.S. and its ability to meet its debt obligations. Treasury Secretary Janet Yellen called the move “arbitrary” and “based on outdated data” that does not reflect the current state of the economy. Recent data showed that GDP grew faster than expected in the second quarter (2.4% on an annualized basis versus 1.8% forecasted) as a resilient labor market buoyed consumer spending. Inflation, meanwhile, is at its lowest level since the spring of 2021, and investor optimism is high. Markets are now pricing in a soft landing despite another rate hike by the Federal Reserve in July.4
Ironically, in the immediate aftermath of S&P’s 2011 downgrade, Treasuries performed well, as investors sold risk assets in favor of the safety of government debt. There were also other macroeconomic issues at the time, including the European sovereign debt crisis. Today, we are seeing a similar story in the markets. The 10-year Treasury yield ended the week +8bps to 4.03% following Fitch’s rate cut on August 1st. We think that some of this increase may be due to the Treasury Department’s announcement made the day before the downgrade that it expects to borrow $1.007 trillion in the third quarter, $274 billion more than initially expected. U.S. stocks ended Friday on a more negative note, with the S&P 500 and Nasdaq Indexes falling 2.3% and 2.8% respectively for the week.
In our opinion, Fitch’s rate cut will have limited near-term market implications due to the depth and liquidity of the Treasury market, as well as the dollar's reserve currency status. Treasuries remain the world's preeminent safe-haven asset during times of stress and the U.S. economy continues to be resilient and reflect long-term strength. Nonetheless, Fitch’s downgrade is a clear warning to the U.S. about the potential challenges ahead if it does not address its surging debt burden, which could result in additional downgrades and weaken investor confidence in U.S. credit and the broader markets. This could motivate Congress to adopt more austere fiscal policies that slow economic growth in the near term, but put the U.S. on a more sustainable long-term debt trajectory.