Tuesday Tidbit: U.S. Debt Gets Downgraded Again — What’s Next?

Last week, Fitch ratings agency announced that it was cutting the U.S. debt rating by one notch, from AAA to AA+. Fitch joined S&P rating agency which previously downgraded U.S. debt similarly back in 2011, ironically under similar circumstances surrounding political infighting around raising the country’s debt limit. Let’s dive a little deeper into why the downgrade happened, the response of the market, and what might come next.

Why Now? In explaining the downgrade, Fitch cited “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.”

The Reaction from Stocks — Stocks moved sharply lower the day after the downgrade was announced. Stocks are still up 10% in the past three months alone. News like the U.S. debt downgrade can often give traders an excuse to sell and lock in profits given the run stocks have had since May.

The Reaction from Bonds — Treasury bond yields have risen since the downgrade, which isn’t surprising. Having a lower credit rating should raise one’s cost to borrow funds in the future. But there may be more to it than that. During the debt ceiling standoff, the Treasury Department held off on issuing more debt to avoid exceeding the debt limit. The Treasury is now in the process of issuing a large sum of debt to replenish its reserves, which also stands to put upward pressure on treasury yields in the short-term.

This Isn’t 2011 — In 2011, S&P was the first rating agency to ever downgrade U.S debt below a AAA rating. It was without precedent. S&P’s decision roiled markets for several months given the unchartered territory U.S. debt had just entered as no longer having the highest credit rating by all three rating agencies. In our view, the Fitch downgrade is unlikely to have much of a market impact given it was only a single notch downgrade and Fitch’s rating is now the same as S&P. This downgrade lacks the precedent of 2011 while the U.S. remains the safest borrower in the world.

A Possible Silver Lining — Like a child who doesn’t clean their room until they risk being grounded, politicians often don’t get serious about negotiating until the financial markets threaten to force their hand as we saw in the debt ceiling debacle earlier this summer. As the fall threatens to usher in a budget brawl between the political parties, one can hope that both parties become more conciliatory following Fitch’s downgrade rebuke.

Every year, the market must climb a wall of worry and historically three out of every four years, stocks find a way to produce positive returns. To date, the 2023 wall of worry includes elevated inflation, recession worries, the Russia/Ukraine war, ongoing Fed rate hikes, three notable bank failures, a debt ceiling standoff, and now you can add a U.S. debt downgrade to the worry wall. And yet, the S&P 500 is still up 18% on the year. In times like these, it’s critical investors recall the price of admission to successful long-term investing is enduring uncertain times like these and staying the course.

Weekly Tidbit Quote: “My rule — and it’s good only about 99% of the time, so I have to be careful here — when these crises come along, the best rule you can possibly follow is NOT ‘Don’t stand there, do something,’ but ‘Don’t do something, stand there!’” — Jack Bogle, founder of Vanguard

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John Fischer, CFA^®, CFP^® | Chief Investment Officer
Mosaic Family Wealth
john@mosaicwealth.com | MosaicWealth.com

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