The Moody’s downgrade highlights the fiscal challenges facing investors, with the debt/deficit already at high levels and set to become even more imbalanced if the reconciliation bill gets passed.
In Brief
- Last week, Moody’s downgraded the U.S. from Aaa status to Aa1, the last major credit rating agency to do so following Standard & Poor’s (S&P) and Fitch downgrades in 2011 and 2023.
- Moody’s cited the increase in government debt and rise in interest costs as reasons for the adjustment.
- The immediate market reaction saw stocks sell off and long-term interest rates rise with the U.S. 30-year Treasury yield jumping to over 5%.
There a few important takeaways for investors as markets digest this news:
- The U.S.’s weakening fiscal position is not new news. As mentioned, Standard & Poor’s first downgraded the U.S. almost 15 years ago for the same concerns around debt burdens, rising deficits, and political gridlock. With Fitch following in 2023, arguably it was just a matter of time Moody’s would follow suit.
- The downgrade could embolden fiscal hawks to push for a lower price tag on the reconciliation package and delay the goal of passage by July 4. The downgrade comes at a time Congress is negotiating a budget package through reconciliation. The Committee for a Responsible Federal Budget (CRFB) projects that the House reconciliation bill could add approximately USD 3.3trillion to the debt by Fiscal Year 2034 by allowing certain provisions to expire before then, with the cost rising to USD 5.2trillion if those provisions are extended.
- We expect limited near-term impact on institutional demand: Despite the downgrade, major institutions and banks are unlikely to be forced sellers of Treasuries due to regulatory rules. On the contrary, potential Supplementary Leverage Ratio (SLR) reform could allow domestic banks to be larger holders of Treasuries over the medium to long term if Treasuries are excluded from leverage calculations.
- Anticipate some volatility in investment grade credit ratings but balance sheet health and default risk are most important for spreads. The “sovereign ceiling rule” is a guideline stating no borrower within a country should be rated higher than the sovereign government of that country. This downgrade, in theory, could trigger a broad re-rating in investment grade (IG) credits; spreads widened in 2011, but remained stable in 2023. Given low defaults and strong corporate balance sheets, we think credit spreads remain stable through this episode.
Overall, while this downgrade is likely to contribute to near term market volatility, we don’t think this dramatically shifts the longer-run narrative. From a fiscal perspective, certain House Republicans will likely point to tariff-revenue and Department of Government Efficiency (DOGE) cuts as an offset to the reconciliation package. However, given they were enacted via an executive order and not by Congress, they are likely to propose tariff revenue as an unofficial “rhetorical” offset to the reconciliation package. Still, any tariff revenues generated over the long term should be offset by lower growth, essentially netting out the deficit- and debt-to-GDP impacts.
The Moody’s downgrade highlights the fiscal challenges facing investors, with the debt/deficit already at high levels and set to become even more imbalanced if the reconciliation bill gets passed. As such, investors should maintain broad diversification globally to offset risks to U.S. exceptionalism.