Rating Agency Fitch Downgrades the U.S. Credit Rating

In the wake of a near-historic default, Fitch Ratings has demoted the credit rating of the U.S. government, highlighting growing concerns about debt and political unrest in the capital. This is the first such downgrade by a leading rating agency in over ten years, suggesting the rising political battles over U.S. fiscal policy are casting a shadow over the $25 trillion global Treasury market. Fitch now ranks the U.S. at "AA+," one level below the top-tier "AAA."

Due to America's track record of honoring its debts, Treasury bonds have earned an essential place in the global market as a virtually risk-free investment offering dependable returns. These Treasury securities are used as a standard against which returns on other stocks and bonds are measured, necessitating higher yields from any alternative securities purchased by investors.

While few investors believe that Fitch's downgrade will immediately affect this role, this marks the first instance of a rating agency lowering its evaluation of the U.S. government's ability to meet its financial obligations on time since Standard & Poor's did so in 2011, following another Congressional standoff over the debt ceiling. Moody's, another major rating firm in the U.S., maintains its top rating for the country.

On Tuesday, Fitch claimed that the downgrade symbolizes a deterioration in U.S. governance over the past twenty years compared to other top-tier economies. Fitch attributed this to recurring political confrontations and last-minute resolutions over the debt limit, undermining fiscal management confidence.

The Biden administration condemned Fitch's decision, blaming the Trump administration for governance issues and maintaining that the U.S. was not at risk of defaulting on its debt obligations. "Fitch Ratings' decision announced today is arbitrary and reliant on outdated data," commented Treasury Secretary Janet Yellen.

Congress passed legislation to suspend the government's borrowing limit in early June, just before Yellen's set deadline for when the government would be unable to pay its bills promptly. The final compromise, setting federal spending limits and raising the debt limit for approximately two years, was reached after months of stalemate between Democrats and Republicans. Fitch had contemplated downgrading the U.S. during this deadlock.

Fitch anticipates the general government deficit will increase to 6.3% of GDP in 2023, up from 3.7% last year. This projected deficit growth is due to weaker federal revenues, new spending initiatives, and a greater interest burden, leading Fitch to forecast a potential U.S. economic recession later this year.

Credit ratings are crucial for institutional investors and day traders when assessing the risk of major borrowers, such as governments and corporations, defaulting on debt. The U.S., which presides over the world's largest economy and its primary currency, is traditionally considered one of the safest borrowers.

Despite Fitch's downgrade, Wall Street is unlikely to abruptly decrease its reliance on Treasury securities as a safe-haven benchmark. However, such moves gradually erode the trust global financial markets place in U.S. government creditworthiness.

Historical instances, such as Standard & Poor's shock downgrade 12 years ago that led to a stock market plunge, give investors a false sense of security. Yet, with Fitch's latest warning, the reality of the U.S.'s fiscal excess is becoming harder to ignore.

The 2008-09 financial crisis and the emergency response to the Covid-19 pandemic accelerated and postponed the impending reckoning. Predictions made in 2007 suggested that federal debt held by the public would decrease to around 22% of GDP in a decade. Now, it's expected to exceed 100%.

During the Federal Reserve's efforts to maintain low interest rates, including cutting the overnight borrowing rate to zero in 2020 and making debt financing manageable for taxpayers, a change is on the horizon. As interest rates rise due to last year's record-high inflation, the CBO predicts that net interest will reach $745 billion in the 2024 fiscal year, about three-quarters of all discretionary spending excluding defense.

The increasing need for financing and rising rates are reducing the U.S. government's ability to alter the fiscal trajectory without taking politically damaging measures. If no such radical steps are taken, borrowing costs will likely increase, crowding out private investment and reducing the value of stocks. The loss of fiscal flexibility could also hamper the response to future crises, necessitating severe domestic trade-offs such as higher taxes, inflation, and benefit cuts.

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