US ratings downgrade – what it means

At the beginning of August, Fitch Ratings, one of the leading credit rating agencies, downgraded the long-term credit rating of the United States government.

The agency lowered the United States government’s debt rating from the highest AAA rating to the lower AA rating. The downgrade is attributed to a “consistent deterioration in fiscal governance standards” and is also linked to the political and institutional complications that arise every year, with Congress facing exhausting negotiations to approve increases in the debt ceiling. The increasing cost of social security programs has also been cited as one of the reasons for the downgrade.

This marks the second downgrade in the history of the United States, following Standard & Poor’s lowering of the rating in response to the government’s handling of the 2011 debt ceiling crisis.

A sovereign credit rating is an independent assessment of a country’s creditworthiness. In other words, the rating evaluates the level of risk associated with a government’s issuance of state securities. Rating agencies operate on a points system to classify the level of risk. Obviously, the downgrade of the United States has caused significant uproar, with consequences for both the stock and bond markets in the following days. Treasury yields surged after the decision, generating volatility in both the stock and bond markets. But what does the downgrade of the United States imply?

What is a sovereign credit rating?

Sovereign credit ratings are used to provide an indication of the quality of bonds issued by governments. Investors use these ratings to guide their investment decisions, and fund managers sometimes rely on ratings to establish rules that guide asset allocation. The points systems vary depending on the agency (the main global ones being Standard & Poor’s, Fitch, and Moody’s). They follow an order ranging from AAA (the highest rating) to D or C depending on the institution considered, with different nuances and intermediate levels that also vary from agency to agency.

To ensure that ratings remain comparable, the evaluations are grouped together into broader categories aimed at providing a more general assessment of the security (such as “investment grade” or “high yield”). These macro classifications are very important because institutional investors, large asset owners like pension funds, and banks have limits regarding the securities they can invest in. Moving from one category to another can have negative consequences on a country’s ability to finance its debt.

But even a downgrade by just one position, in some cases, can have repercussions, the most obvious of which is an increase in financial burdens for debt servicing due to a perceived higher risk of default. The United States government might end up having to pay higher interest on its new issuances, with a debt that has surpassed the record figure of 32 trillion dollars.

It goes without saying that investors don’t blindly rely on the agencies. The downgrade of a sovereign rating usually occurs within a context of financial crisis or political fragility. According to many, the rating becomes more like a snapshot of an already ongoing situation, and a sudden change ends up becoming a short-term destabilising factor rather than a tool that facilitates transparency and price discovery.

What are the medium-term consequences?

As for the United States, however, a separate discussion must be had. US bonds are, indeed, backed by the political, economic, and financial strength of Washington. The first essential point to keep in mind is that American Treasuries undoubtedly remain one of the safest assets within the entire sovereign debt landscape, the quintessential safe asset. The global economic and financial system still revolves inevitably around the USA, and this downgrade doesn’t even slightly diminish its centrality.

American Treasuries will continue to be the most widely used form of collateral in financial transactions. This is partly explained by the fact that American securities remain of very high quality even after the downgrade (the second-best rating at AA+ overall). Additionally, factors beyond credit rating agency assessments play a significant role, such as the liquidity and depth of the repo market in the USA, and simply the nature and quality of the country’s political and legal system.

In other words, American government securities will remain in high demand, both from banks and major asset managers, as well as pension funds. They use these securities precisely to mitigate risk in their allocations. Needless to say, the rating change hasn’t impacted the demand from investors and economic actors who will continue to require the international trade currency, the dollar, since exposure to treasuries remains the least risky way to hold this currency.

Certainly, if the rating were to drop to levels below AA-, it would have implications at least for banks, increasing the necessary capital requirements to hold these instruments on their balance sheets. However, for the moment, this scenario remains highly unlikely, as none of the major rating agencies’ outlooks are negative.

In conclusion, although the downgrade surprised the markets, we believe that the volatility caused in the short term will be absorbed soon, and expectations of inflation, monetary policy, and economic growth will rather steer the fate of American Treasuries.