In early August, the Fitch agency surprisingly decided to downgrade the credit rating of the USA from the highest possible rating AAA to AA +.
This is the first time in more than 10 years that a second rating agency has decided to downgrade the credibility of U.S. debt, causing limited market movement but also significant outrage among U.S. officials.
What is behind Fitch’s decision? Will other agencies decide to review their ratings? What does this mean for markets, and should other countries also fear potential problems?
Fitch warned in May of this year that it would downgrade the credit rating if the United States did not solve the debt ceiling problem.
That problem has been solved by raising the debt ceiling to 2025, but that does not change the problems on which the Fitch agency focused.
The agency pointed to deteriorating management standards in the U.S. over the past 20 years, potential fiscal problems over the next three years, and a massive increase in interest costs in recent years.
In 2020, after the first blow of the pandemic, the annual interest cost on U.S. debt was just over $500 billion. Now it’s nearly $1 trillion, almost double that!
Fitch’s decision, of course, met with the disapproval of U.S. officials, particularly Treasury Secretary Janet Yellen and President Joe Biden.
They emphasized the strength of the U.S. economy, even though projections regarding debt indicate that it will rise from just over 100% of GDP at present to nearly 200% by 2050!
What does history teach us?
In 2011, the United States lost its „crown” of triple AAA. At that time, S&P decided to lower its rating and has not raised it since.
This was a milestone of sorts. Suddenly, the United States was no longer risk-free. The Financial Times wrote that the S&P decision highlighted the weakening financial condition of the world’s most powerful country.
Time magazine showed George Washington with a black eye on the cover, headlining „The Great American Degradation” The market reacted by quaking in the stock market, keeping in mind the context – especially Europe’s fiscal problems and fears of a breakup of the Eurozone.
However, the bond market largely ignored this warning, and bond prices actually rose! This was coupled with capital inflows into safe havens, and despite the credit downgrade, U.S. debt is still considered one of the safest in the world.
Gold benefited greatly, with its prices reaching record highs at the time.
The state of the economy was, of course, different then. Interest rates were still at zero, and the Fed was between one asset purchase program (QE) and another.
Moreover, the European debt crisis was not yet over and was having a positive impact on U.S. assets, with the result that the U.S. S&P 500 index rose by around 20% within 12 months of the S&P decision.
The market always reacts violently the first time. When something happens a second, third, or subsequent time, the market reaction is not as violent.
Moreover, the situation in 2011 showed that the cost of raising new debt in the U.S. did not increase significantly and there was a more significant reaction in the equity, currency or commodity markets.
So, do we have a reason to worry now?
Have rating cuts played a role in other countries?
There are some economies that have never dropped from a triple AAA rating, including Australia, Sweden, or Germany.
On the other hand, there have been negative rating changes in recent history caused by various factors. In the case of Canada, there was a significant increase in spending and thus debt during the Covid 19 pandemic, while in the case of the UK this was related to the Brexit referendum.
However, it has been shown that within a few dozen meetings after the rating downgrade, no negative impact has been observed; very often, these bonds have even increased!
Of course, we are not suggesting that a rating downgrade is positive for the issuer. However, such decisions often reflect only gradual changes and have been treated by investors as a kind of confirmation rather than as new „shocking” information.
Will there be a way out of American debt?
Fitch showed in its decision rationale that fiscal management has deteriorated significantly over the past 20 years. Such warnings had already been issued by S&P in 2011, and Moody’s also hinted in May that it might decide to take such a step.
It’s worth noting that the investment policy of some funds stipulates that money can be invested only in the safest debt instruments with a AAA rating.
So, as a rule, investment committees pay attention to the prevailing rating, and from this point of view, it might seem that Fitch’s decision is decisive, since the prevailing rating for the U.S. isn’t AAA, but AA +.
However, there is a „problem.” The current U.S. debt market is almost five times the size of the total market for all other sovereign issuers with a AAA rating from all agencies, and almost four times the size when considering countries with a prevailing AAA.
So where would the money from U.S. debt go if managers wanted to move it mechanically? Even if U.S. debt doesn’t have special status for a particular institution (which is often the case), it would be easier to change the rules than to actually exit U.S. bonds.
Incidentally, this fact also means that the debt of governments that have retained AAA may be particularly valued by investors (because there is so little of it left).
The U.S. debt is almost 4 times larger than that of countries with the highest credit rating (at least twice AAA). If the U.S. loses the status of the safest debt, will fund managers have nowhere to transfer their funds? Source: IMF, UN, Bloomberg Finance L.P., Macrobond, XTB Research.
So what is the significance of Fitch’s decision?
Empires fall slowly. Fitch’s decision may not currently trigger large market movements, and even those we see, are the result of a surprising moment in which it appeared, not the reasoning behind it.
However, it is a kind of seal of non-acceptance for U.S. economic policy.
Will Washington immediately have a problem with financing the deficit? Absolutely not.
Will the dollar lose its reserve currency status through Fitch? This certainly won’t happen for many years. The decision should be seen as a warning signal that, without changes, the financial hegemony of the U.S. will decline.
This may even be the case with sound economic policy in the face of growing competition from Asia. Fitch, on the other hand, points to risks that could accelerate the passing of the leadership baton. This is how we believe this decision should be viewed.
Article based on a story from XTB Research
