Some thoughts on the U.S. credit rating downgrade 🤔

There's precedent — and that may blunt its impact 🗓

(Source: RawPixel)

On Tuesday, bond rating agency Fitch downgraded its rating on U.S. credit from a pristine AAA to a slightly less pristine AA+.

From Fitch’s announcement: “The rating downgrade of the United States 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.”

That’s not exactly good news.

But how much does this action actually matter for the markets and the economy?

I have some initial thoughts.

First of all, this is not unprecedented. Fitch is arguably just catching up with its rating agency competitor S&P.

On August 5, 2011, S&P downgraded its rating on U.S. credit from AAA to AA+. From their statement at the time: “The downgrade reflects our opinion that the fiscal consolidation plan that Congress and the Administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government's medium-term debt dynamics. More broadly, the downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges to a degree more than we envisioned when we assigned a negative outlook to the rating on April 18, 2011.“

Back then, the U.S. government was entangled in drama around raising the debt ceiling, another event that, as we know from drama earlier this year, is not unprecedented.

But back then, the idea of raising the debt ceiling was new to a lot of people, and the downgrade of U.S. credit was unprecedented at the time. All this is to say that uncertainty was particularly high. And as such, market volatility was understandably high.

Today, we have the benefit of having gone through this experience before. And based on the subdued market reactions immediately following the news, traders and investors seem largely unfazed.

Will investors be forced to sell?

From a technical perspective, there’s the question of whether a credit downgrade will force some investors to sell U.S. Treasury securities. It’s not unusual for funds to state they’ll only hold certain securities holding a certain credit rating.

Goldman Sachs analysts don’t believe this is a major concern. From a research note Tuesday (emphasis added):

We do not believe there are any meaningful holders of Treasury securities who will be forced to sell due to a downgrade. S&P downgraded the sovereign rating in 2011 and while it had a meaningfully negative impact on sentiment, there was no apparent forced selling at that time. Because Treasury securities are such an important asset class, most investment mandates and regulatory regimes refer to them specifically, rather than AAA-rated government debt.

Again, we have the benefit of historical precedent here. The 2011 S&P downgrade was not followed by a fire sale in Treasury securities.

Zooming out 🔭

I can recall only one other time I’ve written about the U.S. credit rating. It was at the top of my October 15, 2021, TKer: 10 truths about the stock market 📈

From the piece (emphasis added):

1. The long game is undefeated

There’s nothing the stock market hasn’t overcome.

“Over the long term, the stock market news will be good,” billionaire investor Warren Buffett, the greatest investor in history, wrote in an op-ed for The New York Times during the depths of the global financial crisis. “In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.”

Since that op-ed was published, the market emerged from the global financial crisis. It also overcame a U.S. credit rating downgrade and a global pandemic among many other challenges. The Dow closed Thursday at 34,912, just 2% from its all-time high.

It’s certainly possible that politicians take Fitch’s downgrade and figure out ways to make the news worse than it really is.

But it seems more likely that the downgrade will go in the history books as yet another event the markets and the economy were able to overcome.

-

Related from TKer:

• A brief note about the debt ceiling... 🫠

• 10 truths about the stock market 📈