Fitch expects US government debt to rise to 118% of gross domestic product by 2025, compared to a median of around 39% for AAA-rated nations. (UBS)

Fitch said 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 relative to ‘AA’ and ‘AAA’ rated peers.”

Fitch expects government debt to rise to 118% of gross domestic product by 2025, compared to a median of around 39% for AAA-rated nations. The news also follows an announcement on Monday that the US Treasury has increased its net borrowing estimate for the third quarter to USD 1tr, up from the USD 733bn forecast in early May.

All else being equal, the move might be expected to push yields higher on US government debt, as investors demand a greater risk premium. But based on historical experience and current economic conditions, we expect yields to fall, and we view US government bonds as most preferred:

Counterintuitively, US government bonds appeared to benefit from a flight to safety by investors following the last such downgrade in 2011. The yield on the 10-year US Treasury fell around 50 basis points in the three days after the downgrade to 2.6% on 5 August. Even 15 trading days later, yields were still 40bps from the day of the downgrade, and around 80bps lower compared to 15 trading days prior to the move. Notably, the fall in German 10-year yields was only around 10bps in the 15 trading days after the US downgrade to 2.2%.

This time, the market response so far has been relatively nonchalant. The yield on 2-year US Treasuries fell 1 basis point to 4.89% while the 10-year yield gained 1 basis point. US Treasury Secretary Janet Yellen observed that the decision from Fitch would “not change what Americans, investors, and people all around the world already know: That Treasury securities remain the world’s pre-eminent safe and liquid asset, and that the American economy is fundamentally strong.”

Outflows from funds that are only able to hold AAA bonds is likely to be limited, in our view. Many major Treasury holders, such as funds and index trackers, have already prepared for the move by changing mandates to specifically refer to Treasuries rather than AAA credit, and are unlikely to be forced into selling given the importance of the asset class.

The economic backdrop favors US government debt, and we expect yields to decline further. Inflation in the US has shown clear signs of cooling, a beneficial development for fixed income. The Federal Reserve’s favorite measure of underlying inflation—the core personal consumption expenditure index excluding food and energy—slowed to an annual 4.1% in June, down from 4.6% in May. That was also the slowest annual rate since September 2021. We expect this downward trend to continue. This has raised the possibility that the Fed’s 25bps hike in July may have been its last in the cycle—or that only one more increase is on the way. An end to tightening would be positive for government bonds. There are also tentative signs that the labor market is cooling—including data showing job openings fell to a more than two-year low in June—another development the Fed will need to see in order to justify halting rate hikes.

So, we continue to advise investors to buy quality bonds, including US government bonds, which offer attractive all-in yields and the potential for capital appreciation if investors start to worry about slowing growth. We prefer five- to 10-year maturities, and our forecast is for the 10-year yield to reach 2.75% by June 2024 from around 4% at present.

Main contributors - Solita Marcelli, Mark Haefele, Krishna Goradia, Christopher Swann, Vincent Heaney

Original report - US government bonds remain attractive despite credit downgrade, 2 August 2023.