Does Fitch’s Downgrade of U.S. Debt Really Matter?

How has Fitch downgrading the U.S. credit rating affected major U.S. and foreign investors?

The timing of Fitch’s decision was strange, as the United States was actually improving on all the metrics that Fitch set out in its ratings watch last year. The national debt has fallen relative to the gross domestic product (GDP). The U.S. economy has avoided a recession even as inflation rates have come down. And President Joe Biden and Speaker of the House Kevin McCarthy were able to reach an agreement to suspend the debt ceiling in June.

Compared to the debt ceiling showdown in 2011, the debt limit increase this June was accomplished with relatively little brinkmanship or drama. Republicans and Democrats don’t agree on much, but they did agree that the United States should pay its bills. There is no near-term risk that the U.S. government will default.

Fitch’s decision also doesn’t seem to have had a significant impact on the bond market. The downgrade didn’t provide any information that sophisticated traders didn’t already know. When a set of U.S. banks were downgraded in early August, money still flowed into the safety of the Treasury market; and when data showed a resilient economy, bond yields rose as would be expected. Long-term U.S. bonds trade at lower interest rates than short-term bonds, suggesting that the market remains confident in their long-term store of value.

Does the downgrade have any implications for the dollar as a reserve currency?

No; the dollar’s role as the main global reserve currency—and the main currency for global payments—isn’t a reward for winning a fiscal beauty context. In fact, excessive fiscal virtue (via restricted government borrowing and a limited supply of bonds) often is an impediment to a currency’s ability to play a big global role.

The dollar’s global role is largely a function of the fact that U.S. Treasury bonds are unparalleled as a global reserve asset. That stems from the size of the U.S. economy and the vast sums the United States has borrowed over time. No other government bond market matches the scale of the $20 billion Treasury market. And no other market is big enough to absorb the bulk of the world’s roughly $12 trillion in reserves.

Germany actually issues so few federal government bonds that it cannot meet the global demand for euro reserves. This has held back the expansion of the global role of the euro – and effectively kept France’s government bonds from becoming the world’s second most important reserve asset. Japan’s government bond market is in theory one of the world’s biggest, but it currently lacks liquidity thanks in part to the scale of the monetary easing operations of the Bank of Japan. China’s capital controls and the small scale of the market for its central government bonds remain an impediment to a bigger international role for the yuan.

The Treasury market offers reserve managers a unique combination of liquidity and yield—which ultimately matters more than whether the Treasury is traded AAA or AA+.

The dollar’s global role also hinges on its continued utility as a means of global payment. Countries in Africa and Latin America that want to trade with each other will generally settle their trade in dollars—and if not dollars, then in euros. The dollar benefits from the fact that it is already so widely used that the financial infrastructure of making payments in dollars is easier and cheaper. The main risk to the dollar’s (and euro’s) role there is the overuse of sanctions, which could force a broader set of countries into alternative ways of settlement, even if they are less efficient.

The last downgrade of this sort, by S&P, came in 2011 in the wake of the Global Financial Crisis and another fractious debt ceiling showdown. How much have governance and the overall U.S. fiscal picture deteriorated since?

The events of 2011 illustrated that a divided U.S. government raises the risk of default. After the events of January 6, 2021, showed that political divisions have reached extraordinary levels, this could be a basis for more concern, even if Congress lifted the debt ceiling without much controversy. The United States would be in better position if the government could simply borrow the amounts authorized through legislation without any debt limit.

There is also no doubt that the overall fiscal picture is now more challenging than in 2011. Mark Sobel, the U.S. Chairman of the Official Monetary and Financial Institutions Forum, drawing on the work of the Congressional Budget Office, observed that a reasonable estimate puts long-term government revenues at about 18 percent and expenditures at around 24 percent. That gap isn’t expected to close under current policies. Absent increased revenue or real cuts to the main areas of U.S. government spending (i.e. defense, health care, and retirement security), the debt-to-GDP ratio will rise over time, meaning that interest payments will also rise. Interest payments over the last ten years have actually been lower than they were in the early 1990s, but that will soon change, indicating there is cause for concern in the next several years. It would make sense for rating agencies to highlight those concerns in 2025, when many of the tax cuts by former President Donald Trump are set to expire—at which point, there will need to be a serious national conversation about the budget.

Do credit rating agencies still play an important role in global finance?

Yes and no. These agencies matter for bonds that have obvious “credit” risk; where there is a real risk of default, such as corporate bonds; and emerging market governments that issue debt in dollars or another foreign currency. A number of institutional investors are required to buy investment grade bonds, so the bonds that fall short of the thresholds for that coveted status systematically pay higher interest rates.

But there is an open question about the role the rating agencies play in the benchmark government bond markets for the world’s major currencies. The ratings from the big agencies do not affect the U.S. government bond market’s status as the deepest and most liquid dollar bond market, and thus the natural benchmark for all dollar issuers. Similarly, French and German government bonds will retain their preeminent status in the euro area, and the same with Japan’s government bonds in the yen market.

Over the last twenty years, the rating agencies have downgraded the United States, France, and Japan without significantly changing the market role of their debt. The Group of Ten countries that issue bonds in their own currencies—and whose bonds are the core monetary asset of their central bank—are all extremely unlikely to default. Fitch no doubt believes that the U.S. downgrade was necessary to maintain consistency with how it rates other low risk sovereigns, as the United States clearly has more debt than Germany or the Netherlands. But if Fitch was strictly basing its ratings on the probability of default – not on comparisons of the size of the amount of debt outstanding – the only real risk to the Treasury market is U.S. politics.