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Earlier this week, Fitch Ratings downgraded its credit rating for the U.S. government from AAA to AA+. At first glance, this news sounds like a big deal. After all, aren’t U.S. Treasury securities considered low-risk investments?
The initial announcement of the downgrade certainly captured investor and economist attention. But looking beyond the headlines, we find that it isn’t likely to have a major long-term impact on markets. To understand why, let’s start with the history of U.S. downgrades and then discuss the reasoning behind Fitch’s decision to downgrade the U.S. credit rating now.
S&P Downgrade
The most recent (and, up until this week, only) downgrade for the U.S. was back in 2011, when S&P downgraded the government from AAA to AA+. S&P has maintained an AA+ rating for the U.S. ever since and currently has a stable outlook for its rating, matching Fitch. The S&P downgrade was largely due to concerns over the willingness and ability of Congress to pay the country’s debts on time following a politically charged debt ceiling standoff.
In some ways, the S&P downgrade echoes the current downgrade from Fitch. Both rating agencies cited rising political dysfunction as a primary cause for their downgrades following contentious debt ceiling standoffs. In both cases, the standoffs were resolved, and the federal government did not default.
Initial Market Reaction
One area where we’ve seen a difference, however, is the initial market reaction to both announcements. Markets sold off immediately following the 2011 announcement, with the S&P 500, Dow Jones Industrial Average, and Nasdaq Composite all down between 5 percent and 7 percent on the first market day after the downgrade. In comparison, we haven’t seen sell-offs of that magnitude with the current downgrade.
Markets were down modestly yesterday. But, on the whole, investors have largely shrugged off the Fitch downgrade. And why shouldn’t they? The U.S. has already had one AA+ credit rating for more than a decade with no major repercussions. Plus, the Fitch downgrade didn’t tell investors anything they didn’t already know on the topics of rising political dysfunction and the state of the U.S. economy.
Fitch’s Rationale
The reason for first highlighting the history of the last U.S. downgrade is because it sets the stage for the current one. Fitch cited a “steady deterioration in standards of governance over the last 20 years” as a key driver of the current downgrade. It also cited other fundamental reasons for its downgrade, including rising deficits, tighter monetary policy, and its expectation for a recession by year-end.
Those factors alone have never led to a U.S. downgrade in the past. In fact, many economists and investors have questioned the timing of this downgrade announcement from a fundamental perspective. After all, the economic reports released since May have largely shown signs of a healthy economic expansion, and the hopes for a soft landing have risen. While it’s certainly possible that we’ll enter into a recession at some point in the short to intermediate term, the ability for the U.S. to pay its debts in the short term is not in question, as the recent threats to payments have come from the political side—not the economic one.
Look Beyond the Headlines
Big picture, this downgrade isn’t expected to be a major source of uncertainty or volatility. As mentioned, it didn’t tell investors anything they didn’t already know about current political dysfunction and the U.S. economy.
Still, this situation serves as a good reminder that while headlines can be alarming and generate short-term uncertainty, diving deeper into the news of the day often reveals the actual event to be far less concerning than the headlines make it out to be.
We’ll certainly be keeping an eye on the health of the U.S. economy and will hear about more debt ceiling standoffs in the years ahead. But for now, the reality is that the economy remains in good shape, and the headline-driven concerns can be safely put to rest, at least for the time being.
