We explain key drivers of Fitch’s August 1 downgrade of the U.S.’s long-term rating and the potential implications on the market, securities, and clients.
On August 1, 2023, Fitch Ratings downgraded the long-term rating of the U.S. to a “AA+ Stable” from its previous “AAA Watch Negative” outlook.
What were the drivers of the downgrade?
Fitch noted that the downgrade “reflects the expected fiscal deterioration over the next three years, a high and growing general government debt burden, and the erosion of governance… over the last two decades that has manifested in repeated debt limit standoffs and last-minute resolutions.”
- Erosion of governance: “In Fitch’s view, 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. In addition, the government lacks a medium-term fiscal framework, unlike most peers, and has a complex budgeting process.”
- Rising government deficits: Fitch expects “…the general government (GG) deficit to rise to 6.3% of GDP in 2023, from 3.7% in 2022, reflecting cyclically weaker federal revenues, new spending initiatives and a higher interest burden. Fitch forecasts a GG deficit of 6.6% of GDP* in 2024 and a further widening to 6.9% of GDP in 2025. The larger deficits will be driven by weak 2024 GDP growth, a higher interest burden and wider state and local government deficits of 1.2% of GDP in 2024-2025 (in line with the historical 20-year average). The interest-to-revenue ratio is expected to reach 10% by 2025 (compared to 2.8% for the ‘AA’ median and 1% for the ‘AAA’ median) due to the higher debt level as well as sustained higher interest rates compared with pre-pandemic levels.”
- Higher government debt: “The GG debt-to-GDP ratio is projected to rise over the forecast period, reaching 118.4% by 2025. The debt ratio is over two-and-a-half times higher than the ‘AAA’ median of 39.3% of GDP and ‘AA’ median of 44.7% of GDP. Fitch’s longer-term projections forecast additional debt/GDP rises, increasing the vulnerability of the U.S. fiscal position to future economic shocks. Note that this year’s debt-to-GDP is 112.9%, ‘well above the pre-pandemic 2019 level of 100.1%’.”
- Medium-term fiscal challenges unaddressed: “Over the next decade, higher interest rates and the rising debt stock will increase the interest service burden, while an aging population and rising healthcare costs will raise spending on the elderly absent fiscal policy reforms. The CBO** projects that interest costs will double by 2033 to 3.6% of GDP. The CBO also estimates a rise in mandatory spending on Medicare and social security by 1.5% of GDP over the same period.”
*Gross domestic product
**Congressional Budget Office
What are the market and investment implications on securities ratings?
- U.S. government debt is no longer rated AAA as two of the three NSRSOs (Nationally Recognized Statistical Ratings Organizations) rate the US below AAA. AA+ is the average rating of the three dominant rating agencies.
- Moody’s rates the U.S. as “AAA, stable outlook”
- S&P rates the US as “AA+, stable outlook”
- Fitch rates the US as “AA+, stable outlook”
- The short-term rating of “F1+” was affirmed, so there is no change to the rating of Treasury Bills.
- The country ceiling for the U.S. was affirmed at AAA.
- We expect that U.S. agency debt will also be downgraded and rated AA+, like that of the U.S.
- As far as agency mortgage pools, “US Agency MBS is assigned the same rating as US government debt” for Bloomberg indexes. Thus, we believe that agency pools will be AA+ rated.
- As the country ceiling was unchanged, we don’t expect any effect on the ratings of municipal debt.
What are potential market and client implications?
- In isolation, we don’t expect the rating downgrade to move yields dramatically higher. However, with the additional funding needs recently announced as well as higher interest costs (due to more debt outstanding and higher interest rates), along with this move in ratings, U.S. Treasury yields could be pressured higher in the short term. These same factors may also influence a steeper curve as longer-maturity yields rise while the front end remains anchored by the Federal Reserve.
- Some investors are required to hold AAA-rated securities only. These investors may need to either reduce or limit their holdings of U.S.-issued or guaranteed securities or modify their investment management agreements (IMAs). However, given the dominant position of the U.S. government in global bond markets and the ongoing status of the U.S. dollar as the world’s reserve currency, we expect investors to modify their IMA to accommodate the U.S.’s lower credit ratings.
- Agency mortgage pools are not actively rated but rather carry the rating of the U.S. government. Thus, we will consider them as having an AA+ rating.
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