How Fitch rating downgrade flags US’ borrowing binge

What has Fitch Ratings done? What is the rating assigned to the US by the Moody’s and Standard and Poor?

Fitch Ratings has downgraded the United States’s long-term foreign currency issuer default rating (IDR) to AA+ from AAA. Standard and Poor had downgraded US sovereign credit rating to AA+ in 2011. It has retained that rating for the US since then. Moody’s however has given AAA rating to US long term sovereign credit. So, after Fitch’s action, two of the three important rating agencies have downgraded US credit rating.

US ratings downgrade: Is it 2011 dejavu for markets or ‘this time it’s different’?  US ratings downgrade: Is it 2011 dejavu for markets or ‘this time it’s different’?  

What is the rationale given by Fitch for the downgrade?

Fitch has pointed towards the bleak US fiscal situation and poor governance over the past decade as reasons for the downgrade. The rating report states, “The repeated debt-limit political standoffs and last-minute resolutions have eroded confidence in fiscal management. In addition, the government lacks a medium-term fiscal framework, unlike most peers, and has a complex budgeting process.”

The rating agency had some alarming projections on US debt. It projects general government deficit to increase to 6.3 per cent of GDP in 2023 from 3.7 per cent in 2022. The government debt-to-GDP ratio is projected to reach 118.4 per cent by 2025 from 112.9 per cent now.

“The US debt ratio is over two-and-a-half times higher than the ‘AAA’ median of 39.3 per cent of GDP and ‘AA’ median of 44.7 per cent of GDP,” states the report.

The report also highlights that interest costs will double by 2033 to 3.6 per cent of GDP and there will be severe shortage of funds needed for healthcare and social security.

What is the implication of the downgrade?

A ‘AA+’ rating from Fitch means that US is no longer among the countries labelled as the safest borrowers, holding AAA ratings. The downgrade has pushed the US further away from the league of countries which enjoy AAA ratings from all rating agencies which include Denmark, Australia, Switzerland, Germany, the Netherlands, Singapore, Sweden and Norway.

But AA+ rating is not too bad and places the US far above most other countries.

Why does the US enjoy a high credit rating despite its fiscal profligacy?

The report points towards several factors which have led to a relatively high AA+ rating. These are, “its large, advanced, well-diversified and high-income economy, supported by a dynamic business environment” and the status of the US dollar as the world’s “preeminent reserve currency, which gives the government extraordinary financing flexibility.”

In other words, the US’ ability to print unlimited amount of dollars which will be used by other countries improves its ability to service debt.

What this downgrade means for debt markets 

The correlation between credit worthiness and borrowing cost is inverse. Lower the credit worthiness, higher the cost of borrowing. So theoretically with US ratings downgraded, its cost of borrowings should be higher. But the practical world has had some strange reactions. In 2011 August when S&P Global Ratings downgraded the US, the US 10 year treasury bond yields declined sharply to 2.31 from 2.55 per cent, in the first trading day after the downgrade on August 5. It further declined to below 2 per cent before end of the year. This is quite contrary to what happens when credit rating is downgraded. There were many plausible reasons for this including, flight to safety as global economic recovery remained weak post the initial bounce-back from the 2008 crisis. 

However this time given the US inflation issues and significantly higher sovereign debt burden, the cost of borrowings may increase, unlike last time. 

What does this mean for equity markets 

Warren Buffet has referred to interest rates as gravity for stocks.  Theoretically, higher interest rates pull down valuation of stocks. So if the cost of borrowing for what is considered the safest borrower in the world — the US Government — is going to increase, it could have the domino effect of increasing cost of borrowing across the board.  Higher interest rates increase the attractiveness of debt as an investment option and also reduce the net present value of future cash flows in valuing equities. So theoretically the US downgrade is negative for equities. Today’s negative reaction across global markets could be a reflection of that, to some extent.