U.S. Credit Downgrade: Impact and Implications

On August 1st, Fitch Ratings, one of the nation’s biggest credit rating agencies downgraded the US federal government’s AAA credit rating by one notch to AA+. While the decision comes after the current administration managed to resolve the debt ceiling crisis and inflation has been coming down for months, the credit rating agency cited specific concerns it has over the future of the US economy, the country’s growing debt load and an erosion in governance relating to the debt ceiling standoffs.

So, what could this mean for you and your finances? Today on Coffee and Cash, we’ll discuss what a credit rating is, what the downgrade means, and some potential ramifications it may have on your finances.

You know how ordinary people like you and me have credit scores?  Well, a credit rating for a country is effectively the same thing.  It is meant to be an independent assessment of the creditworthiness of a business, or in this case the government, with respect to its ability to pay back its loans.  A high credit rating indicates that a country is likely to repay its debts without difficulty whereas a poor credit rating suggests that it might struggle to keep up with its payments or even fail to make them.

Investors and lenders use credit ratings to decide whether to lend money to a business or entity.  Credit ratings also play a large role in determining how much interest an investor should expect to receive to compensate them for the risk involved in lending money to a certain borrower. For example, bonds issued with a high credit rating are generally higher quality with a low chance of default.  For this reason, they are likely to pay less interest than those issued by borrowers with a lower credit rating that are more likely to default.  The riskier a borrower, the more interest they generally have to pay a rational investor to compensate them for the added risk.

Credit ratings date back to the early 20th century. They became more influential after 1936 when federal banking regulators issued new rules prohibiting banks from investing in speculative bonds or in other words, bonds with low credit ratings. The aim was to avoid the risk of default which could lead to financial losses.

The credit rating for the United States government is assigned by three credit rating agencies: Standard and Poor’s or S&P, Moody’s and Fitch Ratings. These three agencies assess the creditworthiness of countries and other entities by evaluating their ability to meet their financial obligations, including paying debt. All three are overseen by the Securities and Exchange Commission or SEC. Each agency uses its own rating scale to assign a credit rating. For example, S&P and Fitch both use a letter-based rating scale with AAA being the highest. This indicates a very low risk of default. Moody’s uses a slightly different scale.

Has the US credit rating ever been downgraded before?  Yes.  The United States has historically maintained a AAA credit rating. The S&P downgraded US debt for the first time in history during the debt ceiling standoff of 2011. The first trading day after the announcement, the S&P 500 plummeted by 6.5% and markets experienced their most volatile week since the global financial meltdown in 2008. It took almost six months for stocks to climb back to their previous highs.

But this time might be different. For starters, the economy is in better shape than it was during 2011.  Second, investors have been through this situation before and they saw that the previous downgrade didn’t raise US borrowing costs significantly or hurt the Treasury markets. US Treasuries actually rose as investors bolted out of stocks. The sense is that the Fitch downgrade is a development that doesn’t really tell us anything about the US economy we didn’t already know. 

That doesn’t mean there are no negative takeaways from this news, however.  First, a lower credit rating generally does increase borrowing costs over time. With a significant debt load like in the US, that could add up to a lot more interest paid overtime.

It could lead to a recession happening sooner than it would have otherwise happened. It could also erode the US dollar, which stands as the most trusted currency for international trade payments.

Analysts have warned that this move by Fitch could limit the number of investors who are able to buy US government debt. Some investors are bound by constraints on the quality of debt they can buy and those that require a perfect credit rating across the three rating agencies will now need to look elsewhere to fulfill investment mandates. Many, however, doubt the impact will be severe, given the sheer size of the Treasury market and the ongoing demand from investors for US Treasury securities.

While this has been deemed as “entirely unwarranted” by Treasury Secretary  Janet Yellen, the reality is that the Fitch downgrade does shine a light on the damage done when politicians use the debt ceiling as a political gambling chip.  It also draws attention to the path that the US is currently on as it relates to a significant increase in debt levels and overspending by the government.  Let’s hope that this serves as a reminder to those in power that there are ramifications for our behavior and the way that we run the country’s finances. 

We’ll continue to watch for market updates and inform you of any impacts through our weekly Sunday morning series, Coffee and Cash. Watch for next week’s episode where we’ll discuss the trades recently made in our client accounts to position you for the second half of the year. 

If you have any questions about your own finances and investments, call us at 518-406-5624 or book an appointment at simmonscapitalgroup.com.

See you next week.