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August Special Market Update – August 2023: Downgrade Drama

August Special Market Update

Downgrade Drama

Earlier this week, the credit agency, Fitch Ratings, downgraded US Treasuries one level from AAA to AA+. They cited a ballooning fiscal deficit and an “erosion of governance” that has led to repeated debt ceiling fights. Per their statement, “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.” While Janet Yellen quickly responded by saying, “Fitch’s decision does not change what Americans, investors, and people all around the world already now; that Treasury securities remain the world’s preeminent safe and liquid asset, and that the American economy is fundamentally strong.” This now gives the US two AA+ vs. AAA ratings which may mean AAA only mandates can no longer hold treasuries.

Fitch had warned about this potential issue back in May when they put the US on a downgrade watch list during the debt ceiling crisis. They now forecast debt to swell to 118% of GDP by 2025 and continue to rise over the long term. This is similar to the S&P downgrade in 2011, but slightly more consequential as it’s not just the flirting with a debt ceiling crisis anymore, its also about the rising cost of interest and the increasing Debt to GDP ratio. Treasury yields have risen especially in the intermediate and long end of the curve, but for now, it’s not a fire sale yet, more of a smolder. So far, the volatility post announcement has been more muted than the 2011 reaction, though it is possible we see more drawdowns and downside pressure of the coming days and weeks as investors digest the implications.

This downgrade is a needed warning on US debt which is becoming more expensive and a higher cost due to the rising rates. The Treasury office now anticipates needing to borrow 1 trillion for the July to September period, up from the $733B predicted in early May. Meaning the US Government is issuing more debt at a higher rate, which will increase ongoing interest costs to keep the US Government solvent. Net interest costs are about 2.3% of current Nominal GDP as of Q2, but they are creeping up to the 3% range, which is a more dangerous level. Interest expense also now represents about 14% of tax revenues, leaving less money to fund appropriations and mandates. We continue to have to issue new bills at 5%+ to keep the lights on, which is increasing the average cost of US debt. Investments typically trade relative to other options and reviewing the other sovereign debt investment options considered high grade (Japan, UK, Eurozone), the US is still very competitive. Currently Australia, Canada, Denmark, Germany, Lichtenstein, Luxembourg, Netherlands, Norway, Singapore, Sweden, and Switzerland are the only AAA rated by S&P 500.

So, take this news in stride, but be monitoring US Dollar reactions, treasury yields, and market levels for a warning that investors are truly dumping US debt and it may become an issue. Treasury auction participation will also be important to judge ongoing demand for US debt. Even with the downgrade, the US is still considered by many the safe haven and safe port in the storm, and the US has many strengths due to its a high-income well-diversified economy. But the spending and brinksmanship will need to be curtailed in order to keep our economy on an even keel. Warning shots have now been fired; time will tell if our government heeds them.