U.S. Government Credit Rating Downgrade: Is It A Big Deal Or Isn't It?
Fitch downgraded its rating on U.S. Treasuries from AAA to AA+, but the markets have had a pretty muted reaction.
For years, we’ve seen Congress and the U.S. government grow more cavalier with their approach to fiscal responsibility. In more ordinary times, it involves running annual budget deficits and watching the federal debt slowly get larger and larger. Since the COVID pandemic, their game has really stepped up. Today, the government operates on an annual deficit of at least a trillion dollars and plays games of political football with the debt ceiling.
This week, their antics finally started to catch up with them. Fitch, one of the big three credit rating agencies, dropped their rating for the U.S. government from AAA to AA+. Among the reasons given for doing so included “expected fiscal deterioration”, a “growing general government debt burden” and an “erosion of governance”.
While a U.S. government credit downgrade sounds like a big deal, the market’s reaction has been relatively muted. Stocks and bonds have both declined in the aftermath, but there’s not a lot here that suggests investors are panicking.
The big mover has been long-term Treasuries, which have fallen more than 4% this week as bond yields continue to rise. That would seem to be a normal reaction given that lower credit ratings usually come with higher interest rates and the markets are adjusting accordingly.
But that’s not what happened in 2011, the last time that the U.S. government’s credit rating (that time by Standard & Poor’s) was downgraded. Back then, the S&P 500 dropped immediately, Treasury prices soared and credit spreads widened considerably and quickly. So why the difference between 2011 and 2023?
The biggest reason is probably that credit conditions were already deteriorating in the lead-up to the 2011 downgrade. There were already plenty of problems building over in Europe and it was viewed by many that the subsequent U.S. government credit downgrade was a sign of those troubles finally showing up in the United States. Therefore, the reaction was much more decisive. Today, the U.S. economy is still in good shape and, while credit conditions are certainly tightening today, there’s not nearly the sense of imminent danger today that there was then.
So then the big question remains…. Is the U.S. credit rating downgrade by Fitch a big deal or not?
The Case For A Downgrade Being A Big Deal
It’s never a good thing to see your credit rating get downgraded because that almost certainly means that the cost of credit is about to go up. We’re seeing that reaction from the markets already and that’s a problem because interest rates on the short end of the Treasury yield curve have already climbed by more than 5% over the past year and a half. The interest expense on existing debt is already rising considerably due to this and will continue to do so as old debt gets rolled over into new higher-yielding debt. A lower credit rating likely means that the cost of issuing new debt will get higher still at a time when it’s already getting to be one of the biggest line items on the government’s balance sheet.
The talking heads in Washington and on Wall Street may not have liked what Fitch did, but the reasoning behind the downgrade is pretty sound. U.S. government debt IS spiraling out of control. Fiscal responsibility IS a problem in Washington. The time when interest expense on this mountain of debt becomes unmanageable IS approaching. We tend to take a myopic view of things and say that since something isn’t breaking right now then it will probably never break, but there’s currently more than $300 trillion of debt globally, both public and private. While U.S. government securities are considered the gold standard of safety & liquidity and the U.S. dollar is the world’s reserve currency, all of that borrowing and spending still comes with limits. Fitch is merely saying the quiet part out loud.
The Case For A Downgrade Not Being A Big Deal
In the grand scheme of things, has anything really changed?
The dollar will remain the world’s reserve currency. Investors and governments worldwide will continue to use U.S. Treasuries. Is anybody really worried about the quality of an investment in Treasuries even after the downgrade? The bottom line is will this result in a major shift away from U.S. Treasuries and/or the dollar and to some sort of alternative, such as the euro, the yen or any other type of sovereign bond?
I think the safe answer is no and that may be part of the reason why the market isn’t freaking out here. It may result in higher Treasury yields (the 10-year yield has risen by roughly 20 basis points), but I don’t think there’s going to be any material operational difference. U.S. Treasuries will remain the standard bearer for quality, liquidity and safety for the foreseeable future.
Verdict
The long-term implications of running up staggering debt loads and playing these games of political chicken can still have long-term consequences, but the short-term risks still seem relatively low. A credit rating downgrade is never a good thing, but I just don’t see this resulting in any major change to how the world does business.
Even though it’s no longer AAA, a AA+ credit rating is still really good and should reinforce the idea that U.S. Treasury securities are still among the safest and most reliable in the world.