Fitch Ratings downgraded U.S. government debt on Tuesday from its highest rating, AAA, to its second highest, AA+, citing an “erosion of governance” and booming federal budget deficit.
“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 over the last two decades that has manifested in repeated debt limit standoffs and last-minute resolutions,” the ratings agency wrote in a statement.
The U.S. national debt currently stands at $32.67 trillion, and Fitch expects it will continue to surge in coming years amid “rising social security and Medicare costs due to an aging population.” By 2025, the agency sees the U.S. national debt burden reaching 118% of gross domestic product, compared to around 39% for AAA-rated nations.
To their point, the Congressional Budget Office expects the federal budget deficit to top $1.4 trillion this year, and annual deficits over the 2024–2033 period to balloon to an average of $2 trillion.
Fitch’s downgrade follows the U.S. Treasury Department’s Monday announcement that it increased its net borrowing estimate for the third quarter to $1 trillion, from its $733 billion May forecast.
The credit rating change also wasn’t totally unexpected. Fitch put the U.S.’s AAA credit rating on “negative watch” in May when lawmakers went down to the wire in their race to secure funding for the U.S. government after hitting the $32 trillion debt ceiling.
Even as the U.S. Treasury rapidly approached the so-called “X-date,” when the federal government can no longer fulfill its financial obligations, a heated debate over the debt ceiling raged on in Washington. Ultimately, a deal was reached and President Joe Biden signed the bipartisan debt ceiling bill on June 2, but that was just three days before the July 5 “X-date.”
Fitch said Wednesday that these “repeated debt-limit political standoffs and last-minute resolutions have eroded confidence in fiscal management.” The ratings agency also warned that tighter credit conditions (or a reduction in the availability and ease of access to loans) coupled with slowing consumer spending could lead the economy into a “mild” recession this year or early next year.
While Fitch’s ratings downgrade won’t immediately impact the sale or creation of U.S. Treasurys, it could eventually lead investors to fear that the federal government could default on its debts. This would force the Federal Reserve to hike interest rates to draw in increasingly cautious buyers, raising borrowing costs nationwide. But most experts don’t believe that will happen anytime soon.
Economists’ take
Economists were quick to rebuke Fitch’s decision to downgrade U.S. government debt, noting that the latest economic data—from low unemployment figures to steady GDP growth—seem to illustrate an improving, not deteriorating situation in the U.S.
“The United States faces serious long-run fiscal challenges. But the decision of a credit rating agency today, as the economy looks stronger than expected, to downgrade the United States is bizarre and inept,” former Treasury Secretary Larry Summers wrote in a Tuesday post on X (formerly known as a Twitter).
In a follow-up interview with Bloomberg, the economist added that he believes the idea that the U.S. is in any way at risk of defaulting on its debts is “absurd.”
“I don’t think that Fitch has any new and useful insights into the situation. If anything, the data in the last couple of months has been that the economy is stronger than what people thought, which is good for the creditworthiness of U.S. debt,” he said. “I can’t imagine any serious credit analyst is going to give this weight.”
Mohamed El-Erian, the president of Queens’ College Cambridge and economic advisor to both Allianz and Gramercy, was also left wondering “Why now?” given the recent strength of the U.S. economy.
“This is surprising,” he told Yahoo Finance, noting that Fitch didn’t present any new information that would have changed its rating since May. “[W]hen you look at the reasoning you scratch your head as to the timing of this.”
Treasury Secretary Janet Yellen was quick to respond to Fitch’s rating decision as well, calling it “arbitrary” and “based on outdated data” in a Tuesday statement. She added that the lower rating on U.S. debt will “not change what Americans, investors, and people all around the world already know: That Treasury securities remain the world’s pre-eminent safe and liquid asset, and that the American economy is fundamentally strong.”
The market impact
Stocks sold off on Wednesday after news of Fitch’s decision to downgrade U.S. government debt. The S&P 500 fell 1.38% on the day, while the tech-heavy Nasdaq Composite fared even worse, dropping 2.17%.
Still, Wall Street’s top economists and strategists don’t seem worried. Alec Phillips, Goldman Sachs chief U.S. political economist, said in a Tuesday note that the ratings downgrade “does not reflect new fiscal information,” and should have “little direct impact on financial markets.”
And Lauren DiCola, director of investment strategy and market research at the wealth management firm Certuity, which manages nearly $4 billion in assets, argued the decision won’t dissuade buyers of Treasurys or cause forced selling.
“We do not expect this to derail confidence in the U.S. regarding foreign buyers of treasuries, as the U.S. treasury market plays such a critical role in global funding markets. Additionally, the treasury market remains the most liquid funding market, and while that may change on the margin over time, we do not think it is a cause for concern over the near-term,” she said.
However, DiCola noted that “the downgrade does bring into focus somewhat of a perennial issue regarding the U.S.’s all-too-familiar affinity with deficit spending.” And while most economists and market strategists pushed back against Fitch’s ratings downgrade, others weren’t so sure.
“Although the Fitch downgrade is being ‘downgraded’ by commentators in terms of its effect on markets…the rating agency's message is stark,” Quincy Krosby, LPL Financial’s chief global strategist, said Wednesday. “Ultimately, if the deficit isn't contained taxes will be raised to the point that the engine of the U.S. economy, the all-important consumer, will have considerably less discretionary income.”
Krosby also warned that in the long run, as the U.S. government takes on more debt, U.S. Treasury yields may need to rise sharply to continue attracting investors that are taking on more risk.
“This would provide direct—and practical—competition to the equity market,” he warned, adding that “the message from Fitch shouldn't be ignored.”
