The United States, boasting the world’s largest and most secure economy, had long upheld this prestigious AAA debt rating, a testament to its flawless track record in meeting debt obligations.

However, recent developments led Fitch Ratings to enact a one-notch downgrade, shifting the nation’s status from AAA to AA+.

In this article, we will be delving into:

  • What happened during the recent Fitch downgrade,
  • What credit ratings are,
  • The role of credit rating agencies,
  • The reasons behind Fitch’s downgrade, as well as
  • The market’s reactions and considerations about this event.

Background Story

In a move that reverberates through global finance, Fitch Ratings decided to lower the U.S. debt rating from AAA to AA+.

This decision echoes a similar downgrade by Standard & Poor’s in 2011, which was also a response to a debt ceiling standoff in Congress.

The recent downgrade reflects concerns over the handling of a recent debt crisis and marks the second time a major rating agency has stripped the United States of its AAA rating.

What are Credit Ratings?

Credit ratings are far more than just alphanumeric labels; they wield considerable influence over financial markets and investor decisions.

A higher credit rating signifies a lower risk of default, inspiring greater investor confidence.

This means that the borrowing costs will be lowered for the entity being rated, as lenders are willing to extend credit at more favourable terms.

In essence, credit ratings help everyone know who’s trustworthy when it comes to borrowing and lending money.

What is the Role of Credit Rating Agencies

Credit rating agencies serve as custodians of financial stability. They scrutinize various factors, from economic indicators to policy decisions, before assigning a rating.

Notably, multiple agencies exist, each employing distinct methodologies. These agencies, such as Fitch, S&P, and Moody’s, operate within a regulatory framework to ensure transparency and accountability.

They then meticulously assess the creditworthiness of governments and private companies, producing comprehensive reports that serve as a foundation for evaluating a borrower’s fiscal health.

As you may have heard, these ratings are often denoted with a combination of letters (such as AAA or AA+), and are more than mere labels; they represent an essential reference point for investors.

A higher credit rating signifies a borrower’s robust financial health, reassuring investors and encouraging them to offer loans at lower interest rates due to the reduced risk of default.

Why did Fitch downgrade United States’ Long-Term Ratings from ‘AAA’ to ‘AA+’?

Now, to address the elephant in the room…

The rationale behind Fitch’s recent downgrade, though not entirely unexpected, sheds light on the United States’ fiscal challenges.

The nation’s debt trajectory has long been on an unsustainable path, and legislative responses have often fallen short of delivering comprehensive solutions.

While Fitch’s downgrade may have grabbed headlines, its impact has been met with cautious responses from economists and analysts.

Impact of Fitch Downgrade on the Bond and Interest Rate Markets

In theory, the downgrade could lead to higher interest rates on US Treasury bonds. This would make it more expensive for the government to borrow money, which could lead to a decrease in government spending and a slowdown in the economy.

But in reality, the global financial stage witnessed subtle ripples rather than seismic shifts. This is not surprising. Because the 2011 Standard & Poor’s (S&P) downgrade of US credit rating never really shook dominance of US debts. In fact, the US issued much more debts subsequently and the interest rates dropped to almost zero.

In fact, S&P was fined $1.5 billion in 2015 by the US government to settle charges that it misled investors about the creditworthiness of subprime mortgage securities in the run-up to the 2008 financial crisis. The fine was the largest ever imposed on a credit rating agency. If you think about it, it may not be a coincidence.

Well, the reason for the downgrade such as a deterioration in governance, concerns regarding social security and Medicare sustainability and a mounting interest expense, isn’t wrong. But this happens two months after the debt ceiling debate has been resolved and with 2Q growth surprising to the upside.

Personally, I feel that the timing is odd, and the Fitch assessment doesn’t tell the markets much they didn’t already know. There could be some other forces at play.

At least for now, investors’ confidence in U.S. Treasury bonds as a safe-haven investment remains largely intact so far, but we do see that the long-term Treasury yield has increased.

In today’s super inverted yield curve environment, this seems to imply that a higher interest rate environment will stay here for longer.

Impact of Fitch Downgrade on the Stock Markets

In the short term, the downgrade could lead to a decline in stock prices. This is because of two reasons:

  • Increased volatility: The downgrade could lead to increased volatility in the stock market, as investors sell off riskier assets and move to safer investments.
  • Increased risk premiums: Higher bond yield could lead to increased risk premiums for US stocks. This means that investors will demand a higher return on US stocks to compensate for the increased risk of default.

For example, when S&P downgraded US rating in 2011, the stock market dropped more than 6% as shown in the graph below.

Source: CITI Index

However, history told us that in the long run, the stock market always bounces back.

Now the question is, how long?

Will the investors view the downgrade as a sign that the US economy is headed for a recession, which will lead to lower corporate profits and lower stock prices?

Join our upcoming webinar…

In order to explore the intricacies of this issue, we need to delve deeper into what really happened and go beyond the news headline of US Credit Rating downgrade.

We will be hosting a live webinar on 23 Aug 2023, where we will help you make sense of:

  • How does a credit rating downgrade affect the stock market and bond markets
  • Is a recession on the horizon?
  • Is a market crash imminent?
  • How should you adapt your investment strategies amidst the current market situation?

These will provide you with crucial knowledge to safeguard your investment without losing the potential opportunities in today’s complex financial climate.

You don’t want to miss out.

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About the Author

Ivan Guan is the author of the popular book "FIRE Your Retirement". He is an independent financial adviser with more than a decade of knowledge and experience in providing financial advisory services to both individuals and businesses. He specializes in investment planning and portfolio management for early retirement. His blog provides practical financial tips, strategies and resources to help people achieve financial freedom. Follow his Telegram Channel to join the FIRE community.
The views and opinions expressed in this article are those of the author. This does not reflect the official position of any agency, organization, employer or company. Refer to full disclaimers here.

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