The Downgrade FED – Washington or Wall Street?
What is a downgrade:
On a high level, credit ratings are meant to denote how safe it is to invest in the debt issued by a country or a company; essentially, it’s the issuer’s creditworthiness. Credit ratings are dominated by three independent agencies: S&P Global Ratings, Moody’s, and Fitch Ratings, all of which issue ratings on a similar sliding scale, starting with AAA as the top-rated investment that goes all the way down alphabetically to D, which typically denotes a default.
The U.S. had proudly held that top-notch rating reflecting its status as the world’s biggest — and safest — economy, which has never defaulted on its debt obligations.
In August this year, one of the three rating agencies, Fitch, downgraded the US by one notch from AAA to AA +, which is still well above investment grade but is only the second time in history we have seen this.
Why did the downgrade happen:
The U.S. Congress has authorized trillions of dollars in spending over the last decades leading to the U.S Debt level almost tripling since 2009. Every year that the government spends more than it collects, it naturally adds to this deficit, broadly known as the debt ceiling, which has now reached a historic high of more than $32 trillion US Dollars (June 2023).
Around 77% of this debt is held by the public, such as individuals, corporations, and foreign nations, who, of course, all require interest payments to hold this debt, and this means that the U.S. government has to pay around $726 billion dollars each year to maintain or service their debt obligations. In this high-interest rate environment dovetailed tax-cutting fiscal policies, these payments have become (A) more expensive and (B) more challenging to pay due to less collected tax.
in June this year, this led to a heated standoff between President Biden and Congress leaders as to whether there should be a suspension or raise of the debt ceiling. This standoff threatened to push the economy into a crisis mode. But Eventually at the 11th hour, Congress approved a deal not to raise the debt ceiling limit to a specific level but instead suspended it entirely until 2025.
Fitch also cited the US Debt-to-GDP ratio as being over 2 and a half times greater than the average AAA-rated state. This increases the likelihood of future economic shocks having a greater impact on the US fiscal position.
This formed the basis of Fitch’s decision to reduce its rating, as they cited the principal reasons as being the federal government’s rising debt burden and political instabilities surrounding the U.S. debt ceiling arguments that have both gotten out of hand.
The outlook going forward:
Fitch has forecasted that the US economy will enter a “mild recession” in the Q4 of 2023 and the beginning of 2024. However, most market participants have shrugged off the downgrade as they believe the decision appears to have more to do with Washington than it does with Wall Street whereby the country’s sharp political divide has been evident for years without any meaningful consequences in markets – in other words, the market saw it coming. However, we did see a small pullback in indices such as the S&P 500 and The Dow Jones U.S Bank Index, which are down around 1.90% and 3% since the downgrade announcement.
Ironically, the market now appears to be pricing in no recession, but as economist David Rosenberg recently said, “Recessions are like an odorless gas. They sneak up on you.”
It’s worth noting that when the S&P downgraded the U.S. Treasurys in 2011, the only other time the U.S has been downgraded, it did cause short-term volatility and a spike in yields, but the bull market in bonds resumed quickly and yields made new lows a month later in the wake of the European sovereign debt crisis.
It’s also important to note that the US dollar accounts for roughly 60% of global reserve currency, indicating that investors all over the world, including central banks and pension funds, hold trillions of U.S. government debt, and we certainly believe that it is unlikely they will sell their debt because of Fitch’s downgrade. The fact is that the U.S. dollar is still seen as a safe haven, and there is a minimal (if not zero) probability that the US will default.
Podcast
Listen to our podcast with Simon Brown on MoneyWeb now for more insights on the downgrade:
https://www.moneyweb.co.za/moneyweb-podcasts/moneyweb-now/us-debt-still-a-long-term-concern/
