By David Enna, Tipswatch.com
We got a surprise announcement yesterday that should surprise no one: Fitch Ratings downgraded the Issuer Default Rating on U.S. debt to ‘AA+’ from ‘AAA,’ with a stable outlook.
This follows by almost exactly 12 years a similar action by Standard & Poors, which downgraded U.S. debt to an AA+ rating on Aug. 6, 2011. S&P has never lifted that downgrade and still has U.S. debt rated as AA+.
The reason Tuesday’s announcement was a surprise is that it precedes a potential — and very likely — U.S. government crisis by two months. From a USA Today report:
Once lawmakers get back to Capitol Hill in mid-September, the House and Senate will be in session for roughly three weeks until the Sep. 30 deadline to pass a federal budget. On Oct. 1, a new fiscal year begins. If lawmakers cannot push through 11 out of 12 separate spending bills, after passing just one before the August recess, the country will face a government shutdown. …
“We should not fear a government shutdown,” Rep. Bob Good, R-Va., declared at an event outside the Capitol this week. “Most of the American people won’t even miss it if the government is shut down temporarily.”
There is little doubt a shutdown is coming. A number of Republicans are pushing for deeper spending cuts than they got in May’s debt-ceiling compromise. A factor that few people realize: The compromise includes language that enforces a 1% cut in federal spending if all 12 appropriations bills are not passed, and each bill must now get a separate vote (they’ve been grouped together in the past in “omnibus” spending bills). From a New York Times report:
The debt-limit agreement imposes an automatic 1 percent cut on all spending — including on military and veterans programs, which were exempted from the caps in the compromise bill — unless all dozen bills are passed and signed into law by the end of the calendar year. Mandatory spending on programs such as Medicare and Social Security would be exempt.
In essence, a few Republican House members could force BOTH a government shutdown and a 1% automatic spending cut, simply by failing to pass one of the 12 appropriations bills.
All this has been known for months, but it took the calendar turning to August for the fire to burn hot. Fitch Ratings saw the fire and acted.
Fitch’s reasoning
Fitch Ratings on Tuesday released a Rating Action Commentary that explains its reasoning. Here are key elements:
Ratings Downgrade: Fitch noted expected fiscal deterioration over the next three years, a high and growing U.S. debt burden, and the erosion of governance reflected in repeated debt limit standoffs and last-minute resolutions.
Erosion of governance. Fitch noted:
- A steady deterioration in U.S. governing standards over the last 20 years.
- Repeated debt-limit political standoffs and last-minute resolutions that have eroded confidence in fiscal management.
- Economic shocks, tax cuts and new spending initiatives that have contributed to successive debt increases over the last decade.
- Limited progress in tackling medium-term challenges related to rising Social Security and Medicare costs.
Rising deficits. Fitch noted: “We expect 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.”
In a nice bit of timing, the U.S. Treasury on Tuesday issued its “Latest Debt to the Penny” report on Tuesday, just before the Fitch announcement. This is an ugly trend:
- Total U.S. public debt, Aug 1, 2023 = $32.6 trillion
- Total U.S. public debt, Aug 1, 2018 = $21.3 trillion
- Total U.S. public debt, Aug 1, 2013 = $16.7 trillion
So in just 10 years, the U.S. public debt has nearly doubled and this increase is not slowing down, especially with much higher interest payments adding to the burden.
Potential for recession. Fitch noted: “Tighter credit conditions, weakening business investment, and a slowdown in consumption will push the U.S. economy into a mild recession in 4Q23 and 1Q24, according to Fitch projections. The agency sees U.S. annual real GDP growth slowing to 1.2% this year from 2.1% in 2022 and overall growth of just 0.5% in 2024.”
Reaction to the downgrade
Let’s watch the CNBC coverage:
Fitch immediately took heat for this decision and naturally the reactions fell along party lines.
White House press secretary Karine Jean-Pierre said, “It defies reality to downgrade the United States at a moment when President Biden has delivered the strongest recovery of any major economy in the world.”
In a statement, Senate Majority Leader Chuck Schumer, D-N.Y., said the Fitch downgrade reflects “reckless brinksmanship and flirtation with default” by House Republicans and that they “must never push our country to the brink of default again.”
Another Biden administration official called this the “Trump downgrade,” attempting to pin the blame on the former administration.
Louisiana’s former Republican Gov. Bobby Jindal tweeted: “S&P downgraded US credit under Obama, and now Fitch has downgraded US rating under Biden. The excessive spending and borrowing must stop.”
Sigh. Could just ONE politician step forward and say, “Both parties caused this problem and both parties will have to work together to solve it”?
All of this parallels what happened in 2011 when S&P downgraded U.S. debt to the same AA+ rating. That downgrade was called “Black Monday” because it caused a 5.5% one-day drop in Dow Jones Industrial Index. It seems unlikely that we will see a similar fall today because financial markets have become inured to these crises. Bloomberg’s report this morning noted, “In financial markets, the move was met with what amounts to a shrug.”
What was really surprising in 2011 is that U.S. Treasurys strengthened after the downgrade and interest rates fell as the stock market roiled. This chart shows the massive moves in Treasurys and the stock market in August 2011:
Again, I don’t expect to see a similar pattern in August 2023. I’ll close with this from Joachim Klement, head of strategy at Liberum Capital, quoted by Bloomberg:
“We think the downgrade of the US credit rating will not have a material impact on equity markets, US Treasuries or the US dollar. While the downgrade came at a surprising moment, it is not unjustified given the large deficit of the US government and the lack of projected deficit reduction in the coming three to five years. But there is no reason to sell US Treasuries or demand an increased risk premium, in our view, since there is no alternative to Treasuries in global bond markets, nor is there any material default risk in the coming decade, in our view. All in all this is a tempest in a teapot.”
Will the downgrade cause me to abandon investments in U.S. Treasurys? No.
Any thoughts? Solutions? Strategies? Post them in the comments area below.
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David Enna is a financial journalist, not a financial adviser. He is not selling or profiting from any investment discussed. I Bonds and TIPS are not “get rich” investments; they are best used for capital preservation and inflation protection. They can be purchased through the Treasury or other providers without fees, commissions or carrying charges. Please do your own research before investing.
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