U.S. credit rating cut for 1st time in 12 years

 U.S. credit rating cut for 1st time in 12 years

On August 1, 2023, Fitch Ratings, one of the world’s leading credit rating agencies, announced that it had downgraded the U.S. sovereign credit rating from AAA to AA+, citing an “erosion of governance” and “repeated debt limit standoffs” as the main reasons for the decision. This was the first time since 2011 that the U.S. lost its top-tier credit rating and only the second time in history.

What is a credit rating and why does it matter?

A credit rating is an assessment of the financial strength and creditworthiness of an issuer, such as a government or a corporation, based on various factors such as its debt level, fiscal policy, economic performance, and political stability. A higher credit rating means that the issuer has a lower risk of defaulting on its debt obligations and can borrow money at lower interest rates.

The U.S. has traditionally enjoyed a high credit rating from the major rating agencies, reflecting its status as the world’s largest economy, the issuer of the global reserve currency, and the provider of the benchmark risk-free asset (U.S. Treasury bonds). However, in recent years, the U.S. has faced growing challenges to its fiscal sustainability, such as rising public debt, widening budget deficits, and political gridlock over the debt ceiling.

The debt ceiling is a legal limit on the amount of money that the U.S. government can borrow to finance its spending. It can only be raised by an act of Congress and the approval of the president. However, since 2011, the debt ceiling has become a source of political conflict and brinkmanship between the two major parties, resulting in several episodes of uncertainty and near default.

What led to the downgrade by Fitch?

The latest downgrade by Fitch was triggered by the prolonged standoff over the debt ceiling that occurred in early 2023. The U.S. reached its debt limit of nearly $31.4 trillion in March 2023 and had to resort to extraordinary measures to avoid defaulting on its obligations. However, Congress and the White House failed to reach an agreement on raising the debt ceiling until late May 2023, just days before a critical deadline.

Fitch said that this episode demonstrated a “deterioration in standards of governance” and a “lack of political consensus” in the U.S., which undermined its confidence in the country’s ability to manage its public finances prudently and effectively. Fitch also warned that the U.S. faced significant fiscal challenges in the medium term, such as rising interest payments, an aging population, healthcare costs, and infrastructure needs.

How did the U.S. government and markets react?

The U.S. government rejected Fitch’s downgrade as “arbitrary and based on outdated data”. Treasury Secretary Janet Yellen said that Fitch’s decision did not reflect the true strength and resilience of the U.S. economy and its institutions and that it would not change investors’ views on U.S. government debt. She also said that the U.S. was committed to maintaining its fiscal credibility and restoring its AAA rating.

The financial markets reacted with mixed emotions to Fitch’s downgrade. On one hand, some investors were concerned about the implications of a lower credit rating for the U.S.'s borrowing costs and global leadership role. On the other hand, some investors shrugged off Fitch’s move as irrelevant or expected, given that S&P had already downgraded the U.S. in 2011 and Moody’s still maintained its AAA rating for the U.S.

The yield on 30-year Treasury bonds rose to the highest level in almost nine months before Fitch’s announcement, reflecting expectations of higher inflation and more bond issuance by the U.S. government to fund its stimulus programs. However, after Fitch’s downgrade, the yield fell slightly as some investors sought safety in U.S. Treasuries amid global market volatility.

What are the implications for the future?

The downgrade by Fitch is unlikely to have a lasting impact on the U.S.'s borrowing costs or economic prospects, as long as investors continue to trust in its ability and willingness to repay its debts. However, it does highlight some of the structural weaknesses and political risks that could undermine the U.S.'s fiscal position and global influence in the long run.

The U.S. will need to address its mounting debt burden and fiscal imbalances in a credible and sustainable manner, while also investing in its human capital, infrastructure, innovation, and competitiveness. The U.S. will also need to reform its debt ceiling mechanism to avoid unnecessary crises and restore confidence in its governance standards.

The downgrade by Fitch is a wake-up call for the U.S., but not a death knell.