07 Aug US Debt Downgrade
In light of the recent downgrade of US debt, our Chief Investment Officer, Nick Ryder, has written the below commentary.
- On August 1, 2023, Fitch Ratings downgraded the long-term sovereign rating of the US one notch, from AAA to AA+. Fitch’s explanation for the downgrade was that it “reflects the expected fiscal deterioration over the next three years, a high and growing general government debt burden, and the erosion of governance relative to AA and AAA rated peers over the last two decades that has manifested in repeated debt-limit standoffs and last-minute resolutions.”
- The rating agency had warned that it might make this step several months ago amid the US debt ceiling standoff. Accordingly, the announcement did not come as a total surprise to the market, given the earlier warning.
- The timing of the downgrade is unusual, however, because it occurs well after the debt- ceiling standoff was resolved and the US economy continues to grow at a healthy pace.
What does this mean about the US government’s ability to pay its debts?
- It’s important first to recognize that this is not about the ability of the US government to pay its debts—which is effectively unlimited due to the government’s taxing power and ability to print money via the Fed. Fitch had warned during the debt-ceiling standoff earlier this year that it was considering a downgrade because a country refusing to pay its debts in a timely way was not entitled to a AAA rating. It is the same reasoning used by Standard & Poor’s rating agency in 2011 when it downgraded US debt to AA+ from AAA.
- We believe that the substantial current (and projected) government budget deficits and the resultant rise in ratio of debt to gross domestic product (GDP) are a concern over the longer run. Our long-term worry about deficits and debt is, however, largely concerned with the implications on inflation, interest rates and the value of the US dollar, rather than on the ability of the US government to pay its debts.
What are the potential market implications?
We currently expect a limited near-term direct impact on financial markets, including Treasury securities for a two key reasons:
- We’ve already lived through this. Markets tend to react most strongly the first time something happens. Since investors lived through the shock of a US downgrade more than 10 years ago, we believe the actual market impact this time will be less significant. It’s worth noting too that in 2011 when the S&P downgraded US debt, yields ultimately fell over the subsequent few months amid a flight-to-quality trade as these developments occurred during a more negative macroeconomic environment marked by the ongoing European debt crisis.
- It’s unlikely there are meaningful holders of Treasury securities who will be forced to sell due to the downgrade by Fitch. We believe that many investor portfolios will remain in line with average credit quality guidelines. In addition, many investment mandates and regulatory regimes generally refer to US Treasury securities directly, rather than AAA- rated government debt. It’s possible, however, that we may see some second-order effects in fixed income markets to the extent that regulated entities and other institutions with strict policy guidelines around ratings may need to de-risk to offset the lower rating of Treasuries.
In the long run, we believe the downgrade is likely to add to already present longer-term concerns about the demand for Treasury securities. While we anticipate that unless elected representatives in government can come to an agreement to slow the growth in debt, some shift away from Treasury assets is likely over the coming decades. That said, we believe such a shift will be gradual in the near-term given that there is presently no clear substitute for US Treasuries in the global economy. The market for US Treasuries remains the largest and most liquid market for “safe” assets in the world.
Ultimately, we believe investors should not overreact to this announcement. And we certainly do not believe that this announcement is cause for long-term investors to alter their well-thought- out investment plans.