On Tuesday, London-based Fitch Ratings downgraded the United States of America’s Long-Term Foreign-Currency Issuer Default Rating (IDR) to ‘AA+’ from ‘AAA.’ This was the first downgrade to U.S. credit ratings since 2011 when S&P did the same. According to Fitch, 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. They stated that the issues have manifested in repeated debt limit standoffs and last-minute resolutions. While these contentions are undoubtedly true, does the downgrade make a difference?
Given the news, you will likely read plenty of scary and fear-mongering headlines. We’ll take a step back and rationally assess what the U.S. downgrade means for investors and markets. You may likely read that U.S. spending on interest payments is nearing an annualized $1 trillion: a scary thought…if you think the U.S. government has a constrained budget like a household, but that’s not how it works. The government doesn’t need to find money before delivering deficit spending: the government is the very issuer of the money the private sector uses. In short, its balance sheet doesn’t work like ours.
Deficit spending creates a hole in the government’s balance sheet and increases our net wealth (think tax cuts or stimulus money), increasing bank deposits in the system. More bank deposits (liability for a bank) imply more bank reserves (assets for a bank) in the system too. When the government issues bonds to “fund” its deficit spending, these reserves can be used to purchase the newly auctioned Treasuries. So while interest payments are rising, it’s not like the U.S. needs to “choose” between spending on interest and spending money in the real economy – its balance sheet doesn’t work like ours. The fundamental limitation to uncontrolled deficit spending is inflation and scarcity of resources (2021-2022 prime example) and not budget constraints typical of a household.
Due to this, it’s helpful to consider whether the downgrade impacts investors and markets:
- Commercial Banks: They are huge buyers of U.S. Treasuries and use them as part of their high-quality liquid assets required by regulation. Based on these regulations, there is no difference in capital requirements for ‘AAA’ or ‘AA’ rated debt.
- Pension Funds / Insurance Companies: They are also large buyers of U.S. Treasuries, which they use as collateral or long-duration assets to match their long liabilities. A one-notch downgrade does not change this use case.
- There are plenty of other use cases and market participants, but these two examples highlight there will be continued demand.
In the short term, markets can overinterpret and overreact, so it’s essential to keep track of how things move, but in the long run, the downgrade should not materially affect markets.
Economy
- U.S. equity markets struggled this week, with the S&P 500 down -2.3%, the Nasdaq down -2.8%, and the small-cap Russell 2000 down -1.2%. July ended well on Monday, but August has been a dose of reality with four consecutive down days to start the month.
- The ISM Services PMI fell to 52.7 in July from a four-month high of 53.9 in June, compared to forecasts of 53. The reading pointed to a slowdown in services growth due to smaller increases in business activity/production and new orders.
- The U.S. economy created 187K jobs in July, below market expectations of 200K, following a downwardly revised 185K in June. The reading is also below the average monthly gain of 312K over the prior 12 months.
- The unemployment rate in the U.S. decreased slightly to 3.5% in July from 3.6% in June and below market expectations of 3.6%.
Stocks
- U.S. equities were in negative territory. Utilities and Technology led the decline, while Energy and Consumer Discretionary outperformed. Value stocks led growth stocks, and small caps beat large caps.
- International equities closed lower for the week. Developed markets fared better than emerging markets.
Bonds
- The 10-year Treasury bond yield increased nine basis points to 4.06% during the week.
- Global bond markets were in negative territory this week.
- High-yield bonds led for the week, followed by government bonds and corporate bonds.
