The U.S. Debt Downgrade
Image courtesy of Andy Feliciotti on Unsplash
By Jon Aldrich
What Does it Mean and How Will it Affect Us?
As you are likely aware, a couple of weeks ago Fitch Ratings, the credit rating agency, downgraded its credit rating for the U.S. Government to AA+ which is one notch below the top AAA grade that is reserved for a select few countries. Fitch cited the debt ceiling which brought the country to the brink of a historic default, rising worries about the growing debt burden, increased government spending programs, and the political dysfunction in Washington. They also noted that higher interest rates are also making the debt more expensive to service. Realistically, these are all valid concerns.
Markets took the news seemingly without too much concern for the most part, unlike the last time U.S. debt was downgraded in August 2011 by Standard & Poor’s (S & P), another rating agency like Fitch and Moody’s. When S & P downgraded U.S. debt to AA+ 12 years ago the S & P 500 fell by almost 7% the next day after the announcement. This time, however, markets snoozed. (NOTE: In 2013 S & P upgraded their outlook on U.S. debt from “negative” to “stable” but has never upgraded it back to AAA)
I do want to also interject that the ratings agencies don’t necessarily have the best track record for creditability as they really missed the boat back in 2008 by keeping credit ratings high for subprime debt, which we all know led to the Financial Crisis of 2008-9. Moody’s, Fitch and others kept the AAA rating on a lot of this debt up until it all went bad during the crisis. They also missed the boat on the creditworthiness of a number of other companies during this time. Since many companies pay the agencies for their credit ratings there can be some inherent conflicts of interest if a rating agency is a bit reluctant to issue a downgrade to a company that is paying for its ratings service. If they want to keep the company as a client, they probably don’t want to upset it too much with negative ratings if they can avoid it.
Also, the assessments by ratings agencies are subjective and more or less an opinion by that agency. There is no specific set of criteria for a downgrade or upgrade to their rating.
What Does This Mean?
Ok, what does this mean in the big picture? Probably not a whole heck of a lot for now, or for the next few years. There were originally worries that interest rates would skyrocket but rates have only moved up modestly and probably not necessarily due to the ratings downgrade, but rather the issuance of more government debt recently, so there may be a bit more supply of U.S. bonds than demand currently. (Back in 2011 when S & P downgraded U.S. debt, interest rates actually fell as investors continued to gobble up all the U.S. Government bonds that they could.
More importantly, the U.S. dollar is still the world’s main reserve currency and there are really no challengers to this throne for a long time. (China is having their own set of financial issues currently and does not look to be a threat to the U.S. reserve currency status for a long time, if ever. And don’t even get me started on the Euro!). Investors all over the world continue to hold trillions of U.S. government bonds (debt) and the Fitch downgrade will not change that. Pension funds, 401k’s, individual investors, foreign governments, etc. will continue to look to U.S. Treasury Notes and Bonds as a safe, secure place to park their funds and actually now earn some serious interest on their investment. It is hard to envision that changing any time soon. Of course, things can turn negative if we don’t get a better handle on the issues here at home, but for the immediate future that is not likely.
In addition, the risks are muted for a mature country such as the U.S. that is the world’s reserve currency and borrows in its own currency. However, that does not mean the risks are non-existent, so let’s discuss those risks:
Risks Going Forward:
If government borrowing continues to increase, it risks putting upward pressure on bond yields as there could be much more supply than demand for U.S. debt and interest rates would have to rise to entice investors. Also, per the Wall Street Journal “Why Fitch Downgrade Matters” interest rates are much higher now than they were at the S & P downgrade in 2011 and interest expense as a percent of Gross Domestic Product (GDP) will climb to 3.7% in 2033 up from 1.9% last year.
Fitch also attributed the lack of political will in Washington to tackle the spending issues. No politician wants to talk about what needs to be done to shore up Social Security, Medicare and other spending programs, so they keep kicking the can down the road. But how long will they be able to keep kicking that can?
Also, the same Wall Street Journal article mentioned how much worse U.S. fiscal metrics are than its peer countries. To give one example: The U.S. is on track to spend 10% of federal revenue on interest by 2025, compared with just 1% for the average triple-A rated country and 4.8% for double-A-rated. Why, then, isn’t the U.S. rating even lower? Because the reserve status of the dollar, the Superpower status of the U.S. and the size and safety of Treasury debt gives the U.S. unprecedented borrowing ability. Also when the you-know-what hits the fan, investors always rush to the safety of U.S. Treasuries as a place to park cash.
Conclusion:
In the near term the Fitch downgrade is not all that big a deal. However, if we continue our current path and do not make some adjustments, there certainly can be ramifications such as much higher inflation, higher interest rates for longer, possible loss of the U.S. status as reserve currency and a miserable investing environment.
We really need to hope that our politicians in Washington can somehow figure out a way to put the country first and ahead of the political party to come up with some compromises and solutions to keep this country great. Like a lot of people, though, I am losing hope in that outcome. But looking on the bright side, this country has dealt with and overcome major adversity before, so I hold out hope that it will again before it is too late.