Moody’s U.S. downgrade is a warning, not a game-changer

Key Takeaways

• On Friday, Moody’s lowered the U.S. sovereign credit rating from Aaa to Aa1 citing the U.S. government’s ongoing fiscal deficits, growing debt burden, and rising interest costs. Moody’s changed the credit outlook from negative to stable. 
• Moody’s downgrade is unsurprising but adds pressure onto the U.S. government to carve a sustainable fiscal path forward.

What happened

On Friday, Moody’s became the final credit ratings agency of the “Big 3” to lower the U.S.’s sovereign credit rating by one notch from Aaa to Aa1. Standard and Poor (S&P) downgraded the U.S. from AAA to AA+ in August 2011; Fitch Ratings cut its rating from AAA to AA+ in August 2023. Moody’s had maintained a negative credit outlook on the U.S. since November 2023.

In the report, Moody’s pointed to the unchecked increase in the U.S. government’s debt load and rising interest burden over the past decade to justify the downgrade. It also noted that the current budget proposals circulating in Washington are likely to add to the deficit substantially over the next decade. Moody’s rationale echoes the sentiments from the previous S&P and Fitch Ratings downgrades, which also underscored the partisan brinksmanship and discord around major fiscal deadlines.

What now

The Moody’s downgrade itself will do little to change the world’s current view of U.S. debt. The concerns cited alongside the downgrade are well-known and continue to be offset by the U.S.’s singularly robust and dynamic economy. However, similar to the S&P and Fitch downgrades, the Moody’s downgrade shines a spotlight on the U.S.’s fiscal challenges and need for a sustainable fiscal path forward. The U.S. government has no issue with meeting its debt obligations and remains one of the most liquid, reliable lenders in the world. The risk of a U.S. default remains extraordinarily low. That said, ratings agencies will likely continue applying pressure on the U.S. government to address the deficit and overreliance on debt issuance until policymakers strike a healthier balance between government spending and revenues. Also, concerns around the federal deficit have been a key driver of higher interest rates this year; investors are demanding greater compensation for holding U.S. debt securities given the country's fiscal imbalances. This, in turn, elevates the country’s interest costs further.

Since “Liberation Day” in early April when the administration unveiled its aggressive trade playbook, global investors have exhibited some aversion to investing in the U.S. Treasury market. While reports of “dumping” U.S. Treasuries are overblown, foreign buyers are diversifying their purchases with other safe-haven alternatives, such as Japanese and European debt. Over the near-term, the Moody’s downgrade may add some momentum to this trend. But, given that the U.S. was already AA-rated by S&P and Fitch, we doubt that the Moody’s downgrade will create a large pool of forced sellers in the U.S. Treasury market.

Bottom line

Moody’s decision to cut the U.S.’s sovereign credit rating from Aaa to Aa1 was a long time coming after placing the U.S. on negative credit watch more than 17 months ago. The concerns used to justify the downgrade are well-known and do not affect the U.S.’s ability to meet its debt service obligations nor raise the risk of default. However, it serves as a stark reminder that the U.S. remains on a fiscally unsustainable path that will need to be addressed over the next decade through a combination of more measured spending and increased revenue collections. We continue to recommend neutral duration for fixed income portfolios given the wide potential outcomes for U.S. fiscal and trade policy.