Special Edition: Fitch Downgrades U.S. Sovereign Debt Rating

U.S. Sovereign Debt Gets Downgraded to AA+

Fitch, one of the top three globally recognized credit rating agencies, downgraded U.S. sovereign credit one notch, from a AAA rating to a AA+ rating. Fitch justified its decision by arguing it reflects “fiscal deterioration over the next three years, a high and growing general government debt burden, and the erosion of governance […] that has manifested in repeated debt limit standoffs and last-minute resolutions.”

Complete rating action commentary is available here.

For historical reference, S&P Global Ratings made a similar credit rating adjustment in 2011 that was never reversed. Moody’s Investor Services still rates the U.S. sovereign debt as AAA, its top rating.

What Was the Catalyst for Fitch’s Decision to Downgrade?

There was no single catalyst that resulted in the downgrade decision. Fitch cites, “a steady deterioration in governance over the last 20 years.” Fitch expects the general government (GG) deficit to be 6.3% of GDP in 2023 (compared to 3.7% in 2022), then 6.6% in 2024 and 6.9% in 2025, “reflecting cyclically weaker federal revenues, new spending initiatives and higher interest burden.” A rising debt-to-GDP ratio increases the U.S.’ vulnerability to future economic shocks.

The U.S. is dealing with a higher interest service burden amid an aging population and rising healthcare costs that will raise spending on the elderly, absent fiscal policy reform. Fitch also cited risks and costs associated with Medicare and Social Security coverage. Fitch labels these as medium-term challenges that have been unaddressed.

The dynamic, diverse U.S. economy is supporting a strong credit rating. High income and the fact that the U.S. dollar is the world’s preeminent currency reserve are structurally significant to the strength of U.S. credit. Tighter monetary policy and Fitch’s projection for a shallow recession in 4Q23 and 1Q24 are near-term components to Fitch’s long-term rating outlook.

Our Take: Why an “Arbitrary” Downgrade Signals More Than the Treasury and White House Let on

The downgrade comes at a point of inflection: net interest costs hit 14% of tax revenue, debt servicing costs are rising for the first time in 35 years and the debt-to-GDP ratio is above 120%. While Treasury Secretary Yellen calls the Fitch downgrade “arbitrary” and “outdated,” she has previously testified that net interest costs at 3% of GDP are dangerous – we should be there in six months.

The Treasury is issuing T-bills at 5.3% to finance fiscal legislation, maintaining market liquidity but not financing the government at the lowest cost to taxpayers. Since Congress passed the debt ceiling, the Treasury has announced nearly $2 trillion of T-bill issuances at a 5%+ rate. The Fed will likely need to cut rates to help the Treasury. The fiscal situation will not improve until federal spending retreats. Federal spending as a percent of GDP was 25.6% in Q2, compared to the 19.8% historical average.

Supporting the Fitch’s reference to “erosion of governance,” policy analysts do not expect Congress to pass the twelve appropriations bills that fund government operations before the start of its new fiscal year on October 1, which would lead to a government shutdown.

Chart 1: Net Interest Costs a Rising Component of GDP, Approaching 3%¹

Chart 2: Federal Debt Increasing Sharply This Summer as Treasury Issues High-Interest T-bills²

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Sources

1. Source: Strategas. As of August 2, 2023.

2. Source: FactSet. As of August 2, 2023.