FAQ on U.S. debt cut

In recent days, Fitch Ratings downgraded the US sovereign credit rating from AAA to AA+. This action was not entirely a surprise, as Fitch had placed the rating on negative review during the debt ceiling negotiations at the end of the second quarter of this year. In 2011, Standard & Poor’s downgraded the rating from AAA to AA+, within a somewhat similar political environment. Below, we share certain points that we consider relevant under a FAQ format.
Is the downgrade a significant event?
While initial sentiment suggested that the rating action does not represent a major event for now, because the economy has performed much better than expected throughout this year, Fitch’s action is a reminder that fiscal dynamics are on a trajectory that will require more attention over a longer-term horizon. In this sense, the downgrade was based on the following reasons: erosion of governance (poor fiscal management and constant political clashes over the debt limit), higher fiscal deficits* for the following years, and an overall increase in public debt. The agency projected debt-to-GDP levels to rise significantly, potentially reaching 118% by 2025. This debt ratio is higher than the 39.3% average of other AAA-rated governments.
What other factors could create more uncertainty about U.S. debt?
So far, it seems that the markets have finished assimilating the downgrade. However, we believe that new episodes of volatility and nervousness among investors cannot be ruled out if the following situations arise:
- Moody’s downgrade. This action by Fitch represents the second time in U.S. history that an agency has downgraded a credit rating. As of now, Moody’s is the only agency with an AAA rating. If Moody’s were to downgrade, the U.S. would no longer be considered AAA, which could impact the mandates that some funds and investors might hold, modestly reducing the attractiveness of owning U.S. Treasuries.
- Economic crisis: In the event that the economy experiences a deeper and more lasting recession, tax revenues could be affected, while spending could increase. This mix would mean that the debt trajectory estimated by the rating agencies could turn out to be more conservative than expected.
Assuming that the economy does not experience a significant recession that causes accelerated deterioration in the U.S. fiscal profile, then this would not be expected to imply a long-lasting problem.
What was the impact on financial markets?
- Equity Market: The news generated a very short-term correction. However, optimism about lower recession expectations, and the possibility that the FED has concluded its interest rate hike cycle, moderating inflation and a defensive performance in corporate earnings, continue to dominate the market’s good mood.
- Fixed Income: Although the instinctive reaction drove Treasury yields up more than 10bp since the announcement, particularly longer maturities, it appears that this dynamic will not have a lasting impact on markets primarily because this cut is still within the parameters of most mandates, so there would not be a massive sell-off by fund managers. In addition, the US continues to have robust creditworthiness and enjoys the most liquid and largest bond market in the world.
*Fiscal deficit: refers to when the government’s total expenditures exceed its revenues (excluding financing).
The S&P 500 Performance Following The Last Credit Downgrade In 2011

Source: Raymond James