Downgrade Déjà Vu

The past month has been marked by relative calm in financial markets, with investors pushing prices higher based on cooling inflation, resilient earnings, and signs of a pause in rate hikes from the Fed. That calm was pierced earlier this week when Fitch Ratings downgraded US long-term government debt from AAA to AA+.¹ The move surprised many investors and government officials who see US Treasuries as one of the safest investments being offered across global financial markets.

This downgrade is a ripple effect from the debt ceiling crisis that arose earlier this year, before being resolved with yet another last-minute deal. Even though the worst-case outcomes were avoided, we are now seeing the consequences of politicians pushing the country into a conversation about potential default. In their press release, Fitch stated that “there has been a steady deterioration in standards of governance over the last 20 years, including on fiscal and debt matters, notwithstanding the June bipartisan agreement to suspend the debt limit until January 2025. The repeated debt-limit political standoffs and last-minute resolutions have eroded confidence in fiscal management.” For a ratings agency that is usually diplomatic in its commentary, this is a direct remark on the risks of political dysfunction, even for an economy as robust as the United States.

Fitch’s announcement evokes memories of a similar downgrade by Standard & Poor’s in 2011. That move came on the heels of another debt ceiling standoff that was resolved at the last minute, and at the time, Fitch and Moody’s maintained their highest rating for US debt. Moody’s is now the lone ratings agency that gives United States government debt the highest score for creditworthiness.

In many ways, credit ratings for bonds are akin to credit scores for individuals. Credit ratings represent an attempt to estimate the level of risk involved in investing in or lending money to a particular business or other entity, including national and state governments and government agencies.²

For individuals, there are three major consumer credit rating agencies and the score they assign influences what interest rate you can get on new debt, such as a mortgage or auto loan. One of the primary differences is that individuals, on average, take on new debt a limited number of times, often with long stretches in between. The impact of a lower credit score may not be felt immediately.

By contrast, the US government issues billions of dollars of new debt every single week, so the rating will immediately create higher interest payments on new debt issued. Even after the downgrade though, the US still enjoys a very high credit rating, and its debt is backed by the full faith and credit of the US government.

Following the initial shock of the downgrade announcement, investors have already stabilized stock prices and assessed the landscape with a bit more perspective – including the memory of how markets navigated a similar event in 2011. This stabilization was aided by a few prominent voices that spoke up to reassure investors and add their viewpoints to the conversation.

Warren Buffett stated that he is not concerned about the Fitch downgrade and confirmed that Berkshire Hathaway continues to buy $10 billion of short-term Treasury bills each week since they are among the safest investments available. Similarly, Goldman Sachs issued a statement that “the downgrade should have little direct impact on financial markets as it is unlikely there are major holders of Treasury securities who would be forced to sell based on the ratings change.” Jamie Dimon, CEO of JPMorgan Chase, also chimed in saying that his bank and global investors still believe “the credit is sound, [and] it should be the highest rated credit in the world.”

It’s important to note that alongside these votes of confidence, all three voices acknowledged that growing US debt and political dysfunction pose a long-term risk, just not one that warrants a downgrade in the present. As additional economic data is released, investors are getting a picture of an economy that has a solid foundation and is navigating inflation better than expected. This downgrade is less about financial fundamentals and more about political will and the process of level-headed governance.

The first time US credit was downgraded, the reaction from investors and politicians reflected the collective shock. The markets slumped temporarily, and President Obama addressed the downgrade in a news conference, with then-Treasury Secretary Tim Geithner angrily denouncing the S&P decision as flawed. This time, the circumstances are similar, but the initial reaction has been more muted.

One key reason for the muted response: Fitch’s rationale about the growing debt burden and the “erosion of governance” is not new information for investors. Both trends have been widely discussed for many years, and investors have already been pricing in political risks and forecasting how current US debt might mean a drag on future growth. Most importantly, the US dollar remains the world’s top reserve currency. Even with the emergence of the Euro and Yuan as global currencies, and the advent of cryptocurrency, the dominance of the US dollar has not been dented. Global investors, including all major central banks around the world, hold trillions of US government debt and that is unlikely to shift simply because of Fitch’s downgrade.

For most investors, including our North Berkeley clients, this news is a reminder that the debt-ceiling debacle did have consequences despite being resolved. It does not, however, warrant changes to allocations in a long-term portfolio. The US dollar is still seen as a safe haven, and US Treasuries continue to offer reliable yield regardless of any incremental adjustment from one ratings agency.

Resources
¹ Losing the AAA rating further removes the US from a small group of countries that still maintain the top-tier rating from all three major agencies. The group of nine are Australia, Denmark, Germany, Luxembourg, Netherlands, Norway, Singapore, Sweden, and Switzerland.

² Credit Rating: What It Is and Why It’s Important to Investors Investopedia