Economic and Market Commentary

U.S. Downgrade a Reminder That Rising Deficits Can Have a Cost

03/08/2023

Mike Cudzil

The sovereign credit rating cut is unlikely to significantly change views toward U.S. Treasuries, but questions about debt sustainability may grow louder over time.

For the second time in 12 years, one of the three main credit rating agencies has stripped the U.S. government – the world’s largest issuer of sovereign debt – of its top-tier triple-A credit rating. While this week’s move by Fitch Ratings is symbolically significant, and carries practical implications for markets as well, we would not expect it to trigger large selling of U.S. Treasuries nor a near-term shift in investor behavior.

Importantly, we do not believe the downgrade reflects new material information concerning the soundness of the U.S. government. U.S. Treasuries continue to be considered the benchmark, risk-free asset class of choice and act as a reference point across financial markets globally. We also do not foresee the downgrade affecting the magnitude or speed of the U.S. Federal Reserve’s rate-hiking cycle in its fight against inflation.

We are currently broadly neutral on U.S. duration – a measure of interest rate risk – and will continue to adjust duration positioning based upon our fair-value range.

Rating reduction redux

Fitch on 1 August 2023 cut its sovereign credit rating for the U.S. by one notch, to AA+ from AAA, citing three main factors:

Expected fiscal deterioration over the next three years
A high and growing general government debt burden
The erosion of governance relative to similarly rated peers over the last two decades that has manifested itself in repeated debt limit standoffs and last-minute resolutions

Fitch had warned in May that a U.S. downgrade might be forthcoming, although that was before Congress reached a debt-ceiling agreement in June.

In 2011, another credit rater, S&P Global Ratings, similarly stripped the U.S. of its top triple-A rating in the wake of a U.S. debt-ceiling standoff. Interestingly, the downgrade at that time led to an increase in investor demand for U.S. Treasuries, pushing yields lower, a testament to the perception of Treasuries as the go-to asset class in times of economic uncertainty.

Moody’s, the third main rating company, maintains its triple-A grade for U.S sovereign debt.

Economic and policy impacts

Despite widespread forecasts of a weakening U.S. economy this year, the timing of the downgrade is notable as recent data have raised doubts about the likelihood of a U.S. recession. Recent data, culminating in the stronger-than-expected second-quarter GDP report, suggest that the U.S. economy is proving more resilient than anticipated as Fed policy rates rise and inflationary pressures moderate.

We still think the U.S. economy will slow in the second half of 2023 from a stall in bank lending, lagged effects of monetary policy, and fiscal headwinds. However, with starting growth momentum now looking stronger, and headwinds from the banking sector potentially more muted, the probability of a near-term recession also looks lower.

Even before the downgrade, we expected limited appetite for any additional fiscal spending regardless of the economic conditions. More broadly, we believe that, over the next five years, given the current level of sovereign debt relative to GDP, fiscal capacity will be more limited than in the past – either by politics or financial markets – and will constrain the ability of fiscal policy to soften future economic downturns. (For more, see our latest Secular Outlook, “The Aftershock Economy.”)

Market impacts

Fitch’s downgrade is another reminder that risks related to deficit spending and debt sustainability, which tend to lie dormant, can arise and spark concerns. That creates the potential for market surprises and volatility, particularly given the diminished capacity for fiscal and monetary support.

In the long term, that could lead to a weaker dollar, higher bond yields, and steeper yield curves. The U.K. liability-driven investment (LDI) crisis last year was a similar reminder that concerns over fiscal stability can arise quickly, and the U.K. could be a canary in the coal mine on long-term fiscal issues.

To help finance rising U.S. borrowing, the U.S. Treasury this week said it will increase the amount of its quarterly bond sales for the first time in more than two years. That could become another source of investor concern and could potentially pressure bond yields higher.

For now, volatility may benefit those investors who remain flexible and are able to take advantage of opportunities when market valuations overshoot. Although rating agencies’ views and rankings are important, we at PIMCO continuously conduct our own credit research. We are constructing portfolios in ways that acknowledge that U.S. economic data have improved, but that focus on owning resilient assets given ongoing risks and macroeconomic uncertainty.