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US Debt Downgrade: What it Means and How it Might Impact Your Portfolio

US Debt Downgrade: What it Means and How it Might Impact Your Portfolio

August 09, 2023

Key takeaways

  • On August 1st, Fitch Ratings became the second of three major ratings agencies to downgrade US government debt from the highest triple-A rating, citing the government’s rising debt burden and political difficulties.
  • Some stock and bond volatility followed, although it was a muted response compared to the 2011 debt downgrade.
  • The market for US Treasuries is the largest, most liquid capital market in the world. Despite the downgrade, US Treasuries remain a very safe investment option for investors.

What happened:

On August 1st, Fitch Ratings made the decision to downgrade the US government's debt rating from the highest AAA rating to AA+. But what exactly does this mean? Picture the United States government's financial situation like an individual's credit score. A lower credit score signals to lenders that a person might face greater challenges in repaying borrowed money. Likewise, the US debt downgrade reflects Fitch's belief that the US government could encounter difficulty in meeting its future debt payments. This situation isn't entirely new; a similar downgrade happened in 2011 when Standard & Poor's, another major ratings agency, implemented a similar downgrade. Moody's is now the only major ratings agency to maintain the highest AAA rating for the US government.

Why they did it:

Fitch cited the “high and growing general government debt burden” as one of the primary reasons for the ratings downgrade.[1] The combination of tax cuts followed by a significant increase in fiscal spending during and after the pandemic has led to an increasingly large fiscal deficit. This means the government is spending more money each year than it is collecting through taxes and other income sources. The debt-to-GDP ratio, a measure of the government’s spending compared to its gross domestic product, rose from 57% in 2000 to around 120% at the end of 2022.[2] This is significantly higher than most other countries with top AAA ratings.

Another driver of Fitch’s decision is the ongoing congressional battle around the debt ceiling. When the US government reaches the maximum amount of debt authorized by Congress, known as the debt ceiling, Congress can vote to either temporarily suspend or increase the borrowing limit. This has occurred 78 times since 1960 and is generally a routine procedure. However, on certain occasions, it has sparked heated debate among politicians and agreements have been made last-minute, bringing the country to the brink of default. While an actual default has never occurred, Congressional brinkmanship has occasionally rattled markets and resulted in several government shutdowns. Fitch stated that the decision wasn’t just prompted by the latest debt ceiling standoff but rather “a steady deterioration in standards of governance over the last 20 years” regarding “fiscal and debt matters.”[3] It is notable that few other countries outside the US even maintain debt ceilings.

How it may impact your portfolio:

The US debt downgrade appears to have more to do with the dysfunction in Washington than it does with fundamental concerns over the ability of the US to make good on its obligations. Some short-term capital market turbulence may result from the downgrade, but we believe the longer-term impact will be limited. When Standard & Poor’s downgraded US Treasuries for the first time on August 5, 2011, the S&P 500 sold off by almost 7% the next day before stabilizing over the following week.[4] This time around, the effect has been more subdued, with US equities dipping around 2.3% in the week following the announcement.[5]

Bonds also experienced a slight decline following the downgrade, with prices dropping close to 1% over the subsequent week as Treasury yields rose. Many factors may have contributed to the rise in yields, but a heightened sense of risk associated with US Treasuries may be partly to blame. The 2011 downgrade also caused a short-term spike in yields, but the bond bull market resumed quickly and yields soon reached new lows.  In today’s market, the primary driver behind rising yields is the Federal Reserve's measures to combat inflation through tight monetary policy. Even so, the downgrade could add additional upward pressure on short-term interest rates.

Fitch’s downgrade highlights the enduring challenges around large and growing levels of US debt, but it doesn’t bring any new risks to the table. The likelihood of a default on US Treasuries is extremely low, short-term political brinksmanship aside. The US government is well positioned to keep making its interest payments thanks to its enormous tax base and ability to print money. Investors still consider US Treasuries to be the ultimate safe haven investment, and the market for US Treasury debt is the largest, and most liquid, in the world.

Alarming news headlines and short-term bouts of market volatility can make it difficult to be a long-term investor, but maintaining a diversified portfolio can help smooth the ride. As always, reach out to your Financial Advisor with any questions or concerns, as we are here to support you on your journey toward achieving your long-term financial objectives.

The views stated in this letter are not necessarily the opinion of Cetera Advisor Networks LLC. Due to volatility within the markets mentioned, opinions are subject to change without notice. Information is based on sources believed to be reliable═ż however, their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results.

[1] Fitch Ratings

[2] St. Louis Fed

[3] Fitch Ratings

[4] Yahoo Finance

[5] Yahoo Finance