- Macro Strategist
Denmark, Intermediary
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The US rating has once again been downgraded below AAA, this time by Fitch. Recall that S&P’s downgrade (also to AA+) in 2011, which followed stalled debt ceiling negotiations, precipitated a spike in market volatility and a flight-to-quality rally that benefited…US Treasuries. The sharp decline in US Treasury yields following that announcement indicated that market participants didn’t question the willingness of the US to make good on its debts and reinforced the status of Treasuries as a safe-haven asset. Today’s market reaction is more muted, with yields modestly higher and some (including Treasury Secretary Yellen) questioning the timing of the decision.
While the timing of Fitch’s decision was never clear, the outcome has been a long time in the making due to constant willingness to pay issues and, more importantly, a deteriorating public-sector backdrop with no credible plan to put it on a sustainable trajectory over the next 10 years. While there do not appear to be many significant forced selling issues due to the loss of AAA status, I think this formal acknowledgment is important for several reasons.
Decoding the downgrade
At the margin, this downgrade increases the probability that term premium (extra yield compensation for longer-term bonds) will start to rise due to both ability and willingness to pay concerns at a time when foreign Treasury holdings have been in structural decline.
Critically, there are fundamental reasons for a higher-term premium absent a downgrade, including, but not limited to:
- Higher average inflation
- Further inflation volatility
- Shifts in global savings and investment balances
At a minimum, it could increase market focus on the public-sector debt trajectory, which has been ballooning since the pandemic. On a stand-alone basis, this debt burden should be a negative for the US dollar. Other developed market countries also face deteriorating public-sector backdrops, although I think governance concerns due to polarization and constant debt ceiling debates are unique to the US.
The bigger issue
The important medium-term question is whether this downgrade represents a catalyst for US Congress to devise a credible fiscal plan. There have been various members of Congress (for example, Senators Romney and Manchin) pushing for such an outcome, but in practice the steps necessary — broadening the revenue base and reducing entitlement spending — are politically unpalatable. Both are politically challenging, especially with an election 15 months away. Neither side has put forward a credible plan, let alone one that would actually reduce debt levels, based on calculations by the nonpartisan Congressional Budget Office.
This said, any signs of progress toward another Simpson-Bowles type of deficit reduction plan would be notable especially as it relates to the long end of the yield curve, which could otherwise be vulnerable to moving higher. If Congress fails to rein in spending and continues to play chicken with the debt ceiling, the backlash in the form of higher borrowing costs from large holders of US Treasuries could be much more punitive than the actions of rating agencies.
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