Downgrading of US debt a ‘symbolic act’, with no imminent budget crisis expected

THE unthinkable has now become quite thinkable. Financial markets are no longer shocked by warnings that US democracy might one day become so damaged and dysfunctional that the world’s largest economy defaults on its debt.

Fitch Ratings briefly rattled markets this week when it cut its rating on the security long considered the global benchmark for financial safety – the US Treasury bond – to AA+, down a notch from AAA. The Dow Jones Industrial Average fell a relatively modest 348 points in the wake of Tuesday’s (Aug 1) decision, a fraction of the losses incurred in 2011 when S&P stripped the US of its AAA.

Explaining why it did so, Fitch – the third-largest US-focused credit ratings agency after S&P Global and Moody’s – cited the repeated acts of brinksmanship by American legislators, who have brought the US to the verge of default three times in just over a decade. Fitch argued that Congress is playing with fire when opposing parties hold their rivals to ransom by threatening to withhold sovereign debt payments.

The repeated “debt limit stand-offs” have “eroded confidence” in the US government’s fiscal responsibility, “notwithstanding the June bipartisan agreement to suspend the debt limit until January 2025”.

What’s worse is these irresponsible stand-offs are happening during an era when the US is accumulating debt at an unsustainable rate, and desperately needs a plan to resolve Medicare and Social Security shortfalls, the Fitch analysts said.

The rationale so far may sound reminiscent of the S&P Global downgrade to US debt during the first debt-ceiling near-financial-suicide pact in 2011. But Fitch also made a more cryptic observation about the deterioration in “governance” in the US.

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By governance, the agency appears to refer to democracy. Indeed, it may not be entirely coincidental that Fitch’s landmark decision came on the same day as the indictment of former US president Donald Trump for allegedly stoking an insurrection at the US Capitol in January 2021. In closed-door meetings with White House officials, Fitch analysts pointed to the attempted coup as evidence of this crisis in governance, CNN reported.

This is a fair enough point. It is commonplace in assessments of emerging-market debt for political violence to affect the perceived creditworthiness of nations. Setbacks for democracy in places such as Thailand and Russia are inevitably followed by downgrades for sovereign debt. If so, why shouldn’t this be the case for the US too?

“From a market perspective, the downgrade is a non-event,” said Chang Wei Liang, a foreign-exchange and credit strategist at DBS Group in a note to clients.

As a symbolic act, however, Fitch’s ratings change represents a powerful warning to investors and political players alike. The US cannot take its position as the centre of the financial world for granted. If Trump and others insist on cultivating political instability and undermining the integrity of democratic institutions, they will invite economic instability and undermine the integrity of the Treasury market.

Like any household under financial stress, the US needs a sober review of the accounts and a disciplined budget to get its house in order, not the histrionics and stonewalling of the Trump age. If the US continues to elect reckless legislators and presidents and cannot adopt a sober and disciplined budgetary approach, it will lose the faith of international credit markets.

Governance, as Fitch calls it, could soon deteriorate further. Trump is the presumptive favourite for the Republican party nomination for next year’s presidential election. He continues to rail against the Justice Department and other democratic institutions, sowing the seeds for new bouts of civil unrest even as he prepares to face trial for the last major bout.

Fitch is not forecasting an imminent budget crisis for the US. The firm noted the nation’s “extraordinary financing flexibility”, reflecting the dollar’s role as the world’s reserve currency and the concentration of wealth and business activity.

“The Fitch downgrade should have minimal negative impact on the allure of US Treasuries,” said DBS’ Chang. He added that there’s a good chance that dollar-denominated corporate bonds could face corresponding downgrades from Fitch, which would have some implications for the broader bond market, even if Fitch has a smaller universe of coverage than its larger rivals.

The shock value of the Fitch downgrade is nothing compared to the 2011 move from S&P.

“The market has reacted negatively, but the impact has been much less severe,” said John Maier, chief investment strategist at exchange-traded funds firm Global X.

“The economic backdrop still favours US Treasury bonds,” said Solita Marcelli, the chief investment officer (Americas) at UBS Global Wealth Management, who foresees a strong balance of the year for US Treasuries.

Markets are not entirely surprised by Fitch’s downgrade. If US democracy continues to deteriorate and confidence in Congress’s fiscal responsibility continues to decline as the ratings agency observes, there will be plenty of other market shocks ahead.