What does the US credit downgrade mean for markets? – Special Report
August 3, 2023 8:28 am
The United States government’s credit rating has been downgraded by Fitch, citing concerns about runaway deficits and rising debt burdens. Riskier assets like stocks fell on the news, while the US dollar traded higher amid a flight to safety. Is this downgrade a game-changer for global markets?
Downgrade
Credit ratings agency Fitch just downgraded the quality of US government debt, from the top tier of AAA down one notch to AA+. The firm justified its decision by pointing to rising government debt levels and no credible plan for bringing spending back under control, especially as an aging population will likely increase social security and Medicare costs in the coming years.
Normally, such a downgrade would be negative for a nation’s bonds and currency. After all, a lower credit score implies that investors are taking on more risk, and often results in higher borrowing costs for a government.
But the United States is a special case, because it is the world’s largest economy and issues the world’s reserve currency. As such, the US dollar rallied in the aftermath, as demand for safe haven assets overpowered any selling because of the downgrade. Something similar played out back in 2011, when Standards & Poors cut its own rating on US debt.
Stock markets suffered some collateral damage, trading lower on Wednesday as investors trimmed their exposure to riskier assets. Admittedly though, the negative reaction was not massive and follows a fierce rally so far this year, so it seems the downgrade simply gave equity traders a reason to take profits on some long positions.
This time is different
Back in 2011, the S&P downgrade caught markets completely by surprise. Some investment funds and banks were only allowed to hold debt that was rated AAA, so they were forced to sell US government bonds. The downgrade also happened at the onset of the European debt crisis, which naturally made investors more nervous.
A lot has changed since then. Most funds have broadened their mandates to allow them to hold ‘government securities’ instead of only AAA-rated bonds, and bank capital rules have been loosened in a similar manner. In addition, it is far clearer today that the US is on an unsustainable debt trajectory, so the Fitch downgrade isn’t so shocking.
Therefore, there won’t be as many forced sellers of US Treasuries this time around, helping to dampen the market impact.
So why did yields spike?
And yet, bond prices fell and the yields on US bonds rose sharply once the dust settled. It would be tempting to say this was caused entirely by the downgrade, but as the saying goes, correlation is not causation.
In other words, there might be other forces at play. Yields started to move higher on Wednesday only after the Treasury announced its plans for debt issuance during the rest of the year, and surprised investors by signaling bigger bond auctions.
Before this announcement, US yields were trading lower, which suggests bond traders were not concerned about the Fitch downgrade, even though US bonds were the asset class that was downgraded.
Market outlook
While the downgrade itself is not a game-changer for financial markets, the Treasury’s updated auction plans might be. The Treasury warned there will be a heavier supply of bonds hitting the markets in the coming months, which will be more concentrated towards longer-term maturities.
In plain English, more bond supply means there will be upward pressure on US yields, which is usually a negative development for stock markets but positive for the dollar. We got a taste of this trading dynamic on Wednesday, after the Treasury’s announcement.
Higher yields on US bonds make the dollar a more attractive investment destination, as investors can earn higher returns by parking their cash in US debt. Similarly, rising yields are detrimental for stocks because if investors can earn a decent return in bonds, which are considered very safe, they are less likely to take chances with riskier assets like stocks.
In short, the Fitch downgrade probably doesn’t mean much by itself, but in combination with the Treasury announcing bigger bond sales in the coming months, it seems to have been the catalyst for a rally in yields. If yields keep rising and climb to new highs for this cycle, that could dampen the rally in equity markets and breathe some life back into the US dollar.
The United States government’s credit rating has been downgraded by Fitch, citing concerns about runaway deficits and rising debt burdens. Riskier assets like stocks fell on the news, while the US dollar traded higher amid a flight to safety. Is this downgrade a game-changer for global markets?
Downgrade
Credit ratings agency Fitch just downgraded the quality of US government debt, from the top tier of AAA down one notch to AA+. The firm justified its decision by pointing to rising government debt levels and no credible plan for bringing spending back under control, especially as an aging population will likely increase social security and Medicare costs in the coming years.
Normally, such a downgrade would be negative for a nation’s bonds and currency. After all, a lower credit score implies that investors are taking on more risk, and often results in higher borrowing costs for a government.
But the United States is a special case, because it is the world’s largest economy and issues the world’s reserve currency. As such, the US dollar rallied in the aftermath, as demand for safe haven assets overpowered any selling because of the downgrade. Something similar played out back in 2011, when Standards & Poors cut its own rating on US debt.
Stock markets suffered some collateral damage, trading lower on Wednesday as investors trimmed their exposure to riskier assets. Admittedly though, the negative reaction was not massive and follows a fierce rally so far this year, so it seems the downgrade simply gave equity traders a reason to take profits on some long positions.
This time is different
Back in 2011, the S&P downgrade caught markets completely by surprise. Some investment funds and banks were only allowed to hold debt that was rated AAA, so they were forced to sell US government bonds. The downgrade also happened at the onset of the European debt crisis, which naturally made investors more nervous.
A lot has changed since then. Most funds have broadened their mandates to allow them to hold ‘government securities’ instead of only AAA-rated bonds, and bank capital rules have been loosened in a similar manner. In addition, it is far clearer today that the US is on an unsustainable debt trajectory, so the Fitch downgrade isn’t so shocking.
Therefore, there won’t be as many forced sellers of US Treasuries this time around, helping to dampen the market impact.
So why did yields spike?
And yet, bond prices fell and the yields on US bonds rose sharply once the dust settled. It would be tempting to say this was caused entirely by the downgrade, but as the saying goes, correlation is not causation.
In other words, there might be other forces at play. Yields started to move higher on Wednesday only after the Treasury announced its plans for debt issuance during the rest of the year, and surprised investors by signaling bigger bond auctions.
Before this announcement, US yields were trading lower, which suggests bond traders were not concerned about the Fitch downgrade, even though US bonds were the asset class that was downgraded.
Market outlook
While the downgrade itself is not a game-changer for financial markets, the Treasury’s updated auction plans might be. The Treasury warned there will be a heavier supply of bonds hitting the markets in the coming months, which will be more concentrated towards longer-term maturities.
In plain English, more bond supply means there will be upward pressure on US yields, which is usually a negative development for stock markets but positive for the dollar. We got a taste of this trading dynamic on Wednesday, after the Treasury’s announcement.
Higher yields on US bonds make the dollar a more attractive investment destination, as investors can earn higher returns by parking their cash in US debt. Similarly, rising yields are detrimental for stocks because if investors can earn a decent return in bonds, which are considered very safe, they are less likely to take chances with riskier assets like stocks.
In short, the Fitch downgrade probably doesn’t mean much by itself, but in combination with the Treasury announcing bigger bond sales in the coming months, it seems to have been the catalyst for a rally in yields. If yields keep rising and climb to new highs for this cycle, that could dampen the rally in equity markets and breathe some life back into the US dollar.
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