On late Tuesday, Fitch Ratings took the step of withdrawing its highly valued triple-A evaluation of the United States government’s creditworthiness, making it the second among the three major credit-rating agencies to do so. This action has ignited a deliberation in Washington concerning matters of expenditure and taxation policies.
Fitch attributed its decision to the mounting debt load carried by the federal government and the challenges the U.S. government has encountered in effectively addressing issues related to spending and taxation. Consequently, Fitch downgraded the rating from AAA to AA+.
The primary drivers behind this shift, as stated by Fitch, are the anticipated decline in fiscal stability over the upcoming three years, a significant and escalating burden of overall government debt, and a decline in governance standards when compared to other nations holding similar debt ratings.
The potential repercussions of this downgrade might not significantly affect the long-term behavior of financial markets or the interest rates that the U.S. government will be required to pay. Here is the essential information to understand:
HOW DID THE GOVERNMENT REACH THIS STAGE? Fitch’s decision follows closely after a recent resolution of a standoff between the White House and Congress regarding the decision to increase the government’s borrowing limit. A consensus was achieved in late May, leading to a two-year suspension of the debt limit and a reduction of approximately $1.5 trillion in expenditures over the next ten years. This agreement was reached as negotiations neared a critical deadline, beyond which Treasury Secretary Janet Yellen had cautioned that the government might default on its debt.
The Biden administration responded with strong disapproval to Fitch’s action. On Wednesday, Yellen criticized the assessment, labeling it as flawed due to its reliance on outdated data. She pointed out that the evaluation failed to acknowledge advancements observed across various indicators, including those linked to governance, that have transpired over the past two and a half years.
“Despite the impasse, we’ve witnessed bipartisan collaboration resulting in the passage of legislation to address the debt limit,” remarked Yellen.
However, Douglas Holtz-Eakin, President of the American Action Forum and former Director of the Congressional Budget Office, supported Fitch’s decision, asserting that the lack of substantial endeavors in Washington to tackle the longstanding budget deficit warranted the downgrade.
He stated, “This pertains to a fundamental imbalance in the long-term context between the growth in our expenditures and our capacity to generate revenue.”
In 2011, Standard & Poor’s similarly withdrew its esteemed triple-A rating of U.S. debt, following a comparable standoff concerning the borrowing limit.
Fitch elaborated that the ratio of U.S. government debt relative to the size of its economy is projected to escalate from nearly 113% in the present year to over 118% by 2025. This percentage, as indicated by Fitch, significantly surpasses the norm for governments holding triple-A and even double-A ratings, exceeding more than two-and-a-half times the typical benchmark.
WHAT IS THE TYPICAL OUTCOME OF A DEBT DOWNGRADE? Rating agencies like Fitch, along with counterparts such as Standard & Poor’s and Moody’s Investors Service, evaluate a wide spectrum of corporate and government debts, encompassing local government bonds to large-scale bank debt.
In general, when an entity’s debt rating experiences a downgrade, it often necessitates offering a higher interest rate. This adjustment aims to counterbalance the heightened potential for default that accompanies the lowered creditworthiness.
HOW MIGHT THIS IMPACT U.S. TAXPAYERS? Numerous pension funds and other investment mechanisms are obligated to exclusively retain assets with elevated credit ratings. In the scenario where a municipality or state, for instance, witnesses a substantial decrease in its credit rating, these investment funds would be compelled to divest any holdings tied to those bonds. As a result, the governing body issuing those bonds would be required to offer a greater interest rate on its future bonds, designed to attract alternative investors.
In the event that this scenario unfolds for U.S. Treasury securities, it could lead to a situation where the federal government becomes obligated to offer higher interest rates. Consequently, this would result in elevated interest expenses for both the government and taxpayers.
IS THERE AN EXPECTATION OF INCREASED U.S. BORROWING COSTS? The consensus among economists is that such an outcome is unlikely to materialize. Instead, experts believe that Fitch’s downgrade will exert minimal influence. Few pension funds are exclusively limited to holding solely triple-A rated debt, according to insights from Goldman Sachs. This suggests that the prevailing AA+ rating from both Fitch and Standard & Poor’s will suffice to sustain demand for U.S. Treasurys.
Alec Phillips, Chief Political Economist at Goldman Sachs, conveyed, “We do not anticipate significant holders of Treasury securities being compelled to sell due to a downgrade.” He expressed this view in a research note.
Furthermore, Alec Phillips noted in an interview that significant U.S. banks, subject to regulatory requirements to retain Treasurys, will not be subjected to rule modifications solely due to the downgrade. Regulatory bodies are expected to continue regarding these investments as secure choices.
For the majority of investors, U.S. Treasury securities are in a category of their own. The U.S. government bond market is the largest globally, making it convenient for investors to buy and sell Treasurys as required. The United States’ substantial economy and longstanding political stability have led many investors to perceive Treasurys as almost equivalent to cash.
The impact of rating agency downgrades is usually more significant for smaller, less recognized debt issuers, such as municipal governments. In such instances, even significant investors might lack comprehensive information regarding the creditworthiness of the bond and rely more heavily on the assessments provided by ratings agencies, as noted by Phillips.
However, this dynamic doesn’t align with Treasury bonds and notes. Prominent investment funds and banks formulate their own evaluations of Treasury securities and don’t heavily depend on ratings agencies, according to Phillips. He also pointed out that Fitch’s analysis didn’t introduce substantial new insights. Similar projections concerning the trajectory of U.S. government debt have been presented by other entities, including the nonpartisan Congressional Budget Office.
Phillips emphasized, “No one is holding Treasuries based on the ratings.”
WHAT DOES FITCH MEAN BY ‘GOVERNANCE’? Fitch’s downgrade is attributed in part to a decline in “governance,” a reference to the recurring conflicts in Washington over the past two decades that have resulted in government shutdowns and even brought the government close to a potential debt default.
Fitch elucidated, “The repetitive debt-limit political standoffs and last-minute resolutions have eroded confidence in fiscal management.”
Simultaneously, Fitch’s mention of “governance” pertains to the inability of legislative compromises to effectively address the fundamental drivers of federal government debt over the long term, particularly concerning entitlement programs for the elderly like Social Security and Medicaid.
Fitch clarified, “There has been only limited progress in tackling medium-term challenges related to rising social security and Medicare costs due to an aging population.”