On Tuesday, August 2, 2023, Fitch Ratings downgraded the US government's credit rating from AAA to AA+. This was a rare and unexpected move that raised concerns about the fiscal health and political stability of the world's largest economy. Fitch pointed to several factors that led to its decision, such as the high and rising level of public debt, the lack of a credible medium-term fiscal plan, and the erosion of governance standards in the US.
This downgrade has significant implications for bond investors, both in the US and abroad. Here are some of the key points to consider:
- The US credit rating downgrade does not mean that the US is defaulting on its debt or that it is unable to service its interest payments. The US still has a very strong capacity to meet its financial obligations, and it benefits from issuing debt in its own currency, which gives it more flexibility than other countries. Fitch also affirmed the US's short-term rating at F1+, which is the highest possible level.
- The US credit rating downgrade does reflect a deterioration in the perceived creditworthiness of the US government, which could increase the borrowing costs for the Treasury and other entities that rely on its guarantee, such as Fannie Mae and Freddie Mac. This could translate into higher interest rates for mortgages, student loans, and other consumer and business loans.
- The downgrade of the US credit rating could also have a negative impact on the confidence and sentiment of investors, consumers, and businesses, both domestically and internationally. This could weigh on the economic growth prospects of the US and its trading partners, and potentially trigger a flight to safety in financial markets. The stock market reacted negatively to the news, with the S&P 500 falling 1.7% on Wednesday, August 3.
- The US credit rating downgrade could also affect the role of the US dollar as the world's reserve currency, which gives the US some advantages in terms of trade and financial stability. If investors lose faith in the US's ability to manage its fiscal affairs, they could diversify their holdings into other currencies or assets, such as gold or cryptocurrencies. This could weaken the dollar and increase its volatility.
- The downgrade of the US credit rating is not irreversible, and it does not mean that the other two major credit rating agencies, S&P Global and Moody's, will follow suit. Fitch said that it could revise its outlook on the US rating to stable from negative if there is evidence of a credible and bipartisan fiscal consolidation plan that would stabilize and eventually reduce the debt-to-GDP ratio. It also said that it could lower the rating further if there is a recurrence of political brinkmanship over the debt ceiling or a significant deterioration in economic performance.
The debt-to-GDP ratio is a measure of how much debt a country has relative to its economic output. It is often used as an indicator of a country's fiscal sustainability and ability to repay its debt. According to the IMF World Economic Outlook Database (April 2021), the level of gross government debt-to-GDP ratio in the US was 132.8% in 2020, which was higher than most other developed countries. According to initial estimates from FRED (Federal Reserve Bank of St. Louis), it was 118.6% in Q1 2023.
For bond investors, the key takeaway is that the US debt rating downgrade is a wake-up call that highlights the need for fiscal responsibility and political cooperation in Washington. It also underscores the importance of diversification and risk management in portfolio construction, as well as staying informed and vigilant about market developments.
For more details about bond investing and benefits of portfolio diversification, please check out our articles "Bond Investing: Should You Own Single Bonds or Rather a Bond ETF?" and "Why Portfolio Diversification Matters Even More Nowadays" on our website Smart Money Diary.
Disclaimer: The scenarios or investment products presented above should not be construed as investment advice. All investments involve some level of risk, and past performance is never a guarantee of future returns. As always, do your own research in order to validate and better understand the underlying risks.
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