America Is No Longer AAA?

One of the debt rating agencies in the U.S., Fitch, just downgraded the debt of the United States to AA from AAA. The last time something like this happened was in 2011 when Moody’s made a similar adjustment. What does this mean?

For one thing, politicians are not happy. Treasury Secretary Janet Yellen indicated this was ill-timed and based on backward-looking data. We will look more into this in a moment. A lower credit rating, like a credit score, means there is higher risk and therefore lenders wish for a higher yield to compensate for the added risk. With that said, AA is still a very good rating, and the Government backs its debt from tax revenue, which they have the authority to raise if needed. Due to the uncertainty this may cause, investors purchased treasury bonds in a bid for a “safe haven” which resulted in interest rates coming down. In the scheme of things, it is not likely much will change from this. Let’s look at some factors that may have caused this shift.

 One major concern is the amount of debt the U.S. has accumulated. At the end of May, there was $31.45 trillion in public debt outstanding. Since the debt ceiling was raised, an additional $1.3 trillion of debt has been added. Going back to 1776 and the founding of our country, it took 207 years to accumulate the same $1.3 trillion we have added in a very short time.

As many may realize, debt is unproductive as you are essentially pulling demand forward. Debt issued by the Government affects money spent in other places and will burden further generations as well as the ability to respond to a crisis, such as the Great Financial Crisis or the Covid Pandemic. Based on the current debt outstanding, the annual interest alone is $970 billion. This is 20% of expected tax revenue of $4.8 trillion. 

As interest rates have risen to combat inflation, this has compounded the effect of debt issuance. There is a legitimate concern for the sustainability of the long-term fiscal situation. During a recession, Economist John Maynard Keynes theorized that government spending can help buffer declines in personal spending and business investment. If there are already large interest payments, this could further crowd out the private sector, as dollars invested in government debt cannot be invested elsewhere in the economy as well as also reduce the strength of crisis response.

Compared to the large correction in 2011, when Moody’s downgraded debt, the market reaction so far has been muted. However, when we focus on the purely economic rationale behind the decision, we see there may be some cause for concern in the long run. While the economic impact may not be known, headlines like this are not good drivers of portfolio decisions. As many of you know we are playing with a defensive posture and will continue to focus on our indicators with a view on the long term. If you have any questions or wish to discuss the economy or the market further, we would love to hear from you!