US Credit Rating Downgraded for the First Time in 12 Years: What will this lead to?

US credit rating downgraded again – What’s happened?

The international rating agency Fitch on August 1  downgraded the US long-term credit rating from AAA, which implies maximum credit quality and minimum default risk, one notch lower to AA+.

In Fitch’s rating scale, this rating means “very low risk of default”, while the debt issuer’s ability to pay its bills, in this case, is not in doubt. Thus, from the “big three” rating agencies at the maximum level of the United States continues to evaluate only Moody’s.

The third of the most reputable international rating agencies, Standard & Poor’s, downgraded the US credit rating to AA + back in August 2011 – for the first time in history. Then the trigger for the decline was the protracted dispute over raising the national debt ceiling between Democratic President Barack Obama and the Republican Congress. The downgrade then led to a sell-off in the US stock market.

This time, the rating downgrade was also preceded by a long uncertainty with an increase in the national debt ceiling. At the end of May, in the midst of a struggle between Democrats and Republicans over the issue, Fitch placed the US rating on “watched” status. However, in the end, the rating downgrade occurred two months after the debt ceiling was raised.

Why did Fitch downgrade US credit rating?

The downgrade of the United States is driven by a projected worsening fiscal position over the next three years, a high and growing government debt burden, and a deterioration in the quality of key indicators relative to its AA and AAA peers over the past two decades,” Fitch explains its decision.

The agency states that the political confrontation around raising the national debt ceiling (MarketsXplora wrote in detail about this here) and a last-minute decision “undermined confidence in fiscal management” in the US.

In Fitch’s opinion, the US debt problems will worsen in the coming years – high-interest rates and a growing volume of debt will increase the burden of servicing it, while costs (primarily social ones) will rise.

Finally, another motive for the downgrade was the “sliding of the economy into recession” – Fitch analysts, unlike the Fed and the US Treasury, are waiting for it at the end of 2023 – the beginning of 2024.

Related: Soft Landing: Why the US economy will avoid recession and how it will affect the dollar

The prerequisites for a downgrade in the US rating began to emerge during the period of fiscal mega-stimulus to restore the economy after the coronavirus epidemic, said Alexei Tretyakov, CEO of Arikapital Management Company.

In 2020, the US federal budget deficit exceeded 15%, and in 2021 – 10%. This led to a jump in public debt. The Fed’s rate cut helped to avoid a downgrade, since at a low rate, interest costs on public debt are insignificant, explains the expert.

But after the Fed began raising rates last year, the problem of rising public debt has again become apparent, he continues. Interest expenses on public debt during the year approached $1 trillion, which is one and a half to two times more than the pre-COVID period.

US credit rating downgrade meets criticism

Despite the situation around the US national debt, Fitch’s decision came as a surprise to some economists polled by Bloomberg.

The United States faces serious long-term fiscal challenges, former Treasury Secretary Larry Summers agreed with Fitch’s claims. But the decision to downgrade the US rating when the country’s economy is behaving stronger than forecasts is strange and inappropriate, he said.

In the second quarter of 2023, US GDP grew by 2.4% compared to the same period last year. This turned out to be significantly higher than analysts polled by Reuters (1.8%) had predicted. It is also more than real GDP growth in the first quarter of this year (2%).

Biden administration officials also criticized Fitch’s decision.

This decision is based on old data and does not reflect the current situation in the US economy. It does not change what Americans, investors and people around the world already know: Treasury securities remain an exceptionally safe and liquid asset, and the US economy is fundamentally stable and strong, said Treasury Secretary Janet  Yellen.

On the one hand, Fitch tried to fulfill its professional obligations – key US indicators relative to other AAA-rated countries have been deteriorating for a long time, and there are no fundamental changes in the situation with public debt yet, says Stephen Ethan, market analyst at MarketsXplora.

But on the other hand, there may be some political context: in the face of the uncertainty around the talks to increase the public debt in May, Fitch did not want to create even more negativity around the situation, which is probably why it postponed the decision to downgrade the US long-term rating ‘, he suggests.

What does the current US credit rating mean for the markets?

Experts do not expect a significant decline in the stock market, as in 2011 after the downgrade of Standard & Poor’s. Macroeconomic and other indicators are very different from those in 2011, indicates Chris Harvey, Head of Equity Strategy at Wells Fargo & Co.

Then the stock market was in a bear cycle, interest rates were at a minimum level, and the US economy was much less stable compared to current realities, he continues.

The downgrading of the credit rating does not affect market rates or the economic situation in the country in any way, agrees Vasily Karpunin, head of the information and analytical content department at BCS World of Investments.

Today we do not see any excessive and emotional sales in S&P 500 futures. It is likely that in a few days everyone will forget about this event, he suggests.

Nevertheless, trading on August 3 opened with a noticeable decrease – the S&P 500 fell by 1.2%.

The impact on the profitability of American Treasuries will be limited, says Ethan. Typically, the assessments of rating organizations determine how much interest the borrower is willing to pay to raise funds from the market.

The lower the long-term rating, the higher the yield the issuer should offer due to the greater financial risks. But Bloomberg recalls that even in 2011, when investors were much more concerned about the stability of the US economy, Standard & Poor’s downgrade did not have long-term consequences.

Many investors purchased US Treasuries against the backdrop of uncertainty, and at the end of the year, the yield on the country’s public debt did not increase, but even decreased.

No one is seriously considering the prospect that the US will someday be unable to service its debt. Eric Winograd, chief economist at AllianceBernstein, is categorical.

How will it affect the dollar?

The downgrading of the credit rating is unlikely to significantly affect the dollar, says Ethan.

“Dynamics in credit ratings are usually not the main factor that affects currencies,”  said  Carol Kong, currency strategist at Commonwealth Bank of Australia.

However, if the news causes any sort of panic in the US market, the US currency could underperform some other major competitors such as the euro and yen, suggests Nomura strategist Andrew Ticehurst.

While the dollar feels stable: on August 2, the DXY index, which shows the rate of the US currency against a basket of six major world currencies, rose by 0.5%.

Read also: De-Dollarization: 3 reasons why USD is losing its dominance

Although the impact of the downgrade factor is limited in the short term, this event demonstrates the damage that the constant debate over the national debt ceiling causes to the United States, which every time brings the country to the brink of default, experts interviewed by Reuters said.

The US economy will remain broadly strong, but the second downgrade by an international credit rating agency has left a hole in our armor. This is definitely a blow to the reputation and position of the United States, concludes Michael Shulman, chief investment officer at Running Point Capital Advisors.