Fitch cited a “deterioration in the standards of governance” and “repeated debt-limit political standoffs and last-minute resolutions” to recurring debt ceiling stalemates as contributing factors in its decision to reduce its assessment of the credit quality of US government securities. The Biden administration reacted with a swift denunciation of the ratings agency's decision, calling it “arbitrary and based on outdated information.”
While some market observers have expressed bewilderment at the timing of the Fitch decision, we are inclined to believe the announcement reflects a more deliberative process at the ratings agency. Unlike the decision by Standard and Poor’s in 2011, which lowered its own rating on US government debt within days of the resolution of a debt ceiling impasse, Fitch’s decision to release a revised rating months later suggests to us an attempt to place their decision in the context of broader budgetary and policy challenges.
The US is plagued by a dysfunctional budget process, an escalating deficit, and an artificially constructed debt ceiling that is highly counterproductive for a nation whose currency serves as the basis for most global commercial transactions. Moreover, the federal government now faces the looming prospect of another shutdown in October. Fortunately, while ratings downgrades are often characterized as unwarranted by the recipient, we believe the longer-term impacts will be quite limited.
Among fixed income securities, it is important to remember that the market reaction in 2011 preceded the full implementation of Dodd-Frank regulations. In today’s environment, commercial banks remain large buyers of US Treasuries, and the risk weighting of US sovereign debt remains at zero. The Basel regulatory framework also imposes a 0% capital requirement for bonds rated between AAA and AA, so for banks, this downgrade makes little to no difference. Furthermore, the ratings agency downgrade is a longer-term rating assessment. We do not anticipate an impact to short-term repo or funding markets. The downgrade by Fitch to AA+ should not impair the ability to execute repo transactions by large institutions, money market funds, or banks.
The move in fixed income markets post-announcement was immaterial. The short end of the US Treasury yield curve moved lower by less than 10 basis points, and large market drivers such as the CFTC (Commodity Futures Trading Commission) and CME (Chicago Mercantile Exchange) reference the intrinsic value of US Treasuries—not third-party ratings agency assessments. The recent announcement of approximately USD 1 trillion net new supply of Treasuries into the market this quarter, followed by roughly another USD 850 billion in the fourth quarter, will be the more relevant factor affecting investor appetite, in our view. As the Federal Reserve nears the end of its rate-hiking cycle, the increase in net new supply and persistent quantitative tightening will be dominant factors. We continue to believe that benchmark 10-year rates will be range-bound and are positioned to decline a bit from current levels by year-end, alongside a steepening of the yield curve in the second half of 2023.
Global equity markets have reacted negatively to the news, but the sell-off is quite minimal in the context of the very strong market gains this year. Over the longer term, the outlook for US equities will depend on the health of corporate earnings, the consumer, and the economy. The rating action will likely have an immaterial impact on the cost of capital for US businesses and households. However, in the coming years, a period of deficit reduction seems necessary to get the US government finances on a more sustainable trajectory, which could weigh on economic growth.
Still, those policy actions are not likely in the near term. Instead, in the months ahead, equity markets will continue to be primarily driven by the Fed’s ability to navigate a soft landing in its fight to get inflation under control. In the very short term, investor focus could quickly shift back to the micro as investors weigh earnings results from the mega-cap tech companies.
Main contributors: Thomas McLoughlin, Leslie Falconio, Nadia Lovell
Original report: A surprise downgrade , 2 August 2023.