Fitch Ratings downgraded the US government’s credit rating on August 1st. Fitch took the rating down to AA+, one notch from the previous AAA rating. We believe this is a combination of Fitch’s view of the large US government deficit and the standoff between President Biden and House Republicans earlier in the summer over extending the US debt ceiling. Fitch cited general erosion of governance, a rising US debt burden, and increasing issuance of US government debt going forward among the reasons for the downgrade.
We have experience on this from 12 years ago, when Standard & Poor's cut the US rating to AA+ from AAA in August 2011. At the time, many themes were in place that are resonating today, including government deficits and, more importantly in our view, dysfunctional government. The ten-year US Treasury yield response? It immediately started dropping, with the ten-year yield declining from 2.56% on August 5th 2011 to 2.00% a month later and closing the year at 1.88% (graph below), a drop of 68 basis points from the time of the downgrade to the end of the year.
We think the driver on the bond side in 2011 was a reaction to the dysfunctional government that the budget impasse represented. The Dow Jones Industrial Average dropped from 11,444 to 10,809 the day after the downgrade, a fall of 5.5%. (That would be a 1,950 drop in today’s market.) But the Dow (partially driven by low interest rates) rebounded to finish the year at 12,217, a rise of 6.25% from the day before the downgrade.
What happens because of this new downgrade? We do feel the markets will react less than they did 12 years ago, in part because subsequent events usually produce more muted results than original ones (think about the banking crisis of March). And even though these downgrades were twelve years apart, we think that still holds true.
We still have dysfunctional government and will probably have it for a while until the pendulum swings back to more cooperation between parties. And we do have plenty of issues in front of us. Most immediately, for the US Treasury, is a lot of upcoming issuance, the majority of which is refinancing of debt rolling over, but there will be some new money debt as well.
There is no question that markets have increased perceived risk through credit default swaps on US debt. Below are the credit default swaps on 10-year US debt going back 2 years and 5 years. You can see the spike in CDS based on the debt ceiling impasse and the possibility of a US default this spring. But even after retreating from those highs, credit default swaps are still twice as high as they were at the end of 2021. This is a caution sign. My colleague David Kotok wrote about this last week: https://www.cumber.com/market-commentary/cost-debt-ceiling-crisis.
In other words, the Fitch downgrade maybe harbors a refocus on the continued deficits as well as the fiscal policy producing them. As of Friday morning August 4th, the ten-year US Treasury bond is up 14 basis points in yield and the 5-year bond is unchanged. But the roller coaster week in yields certainly reinforced the dysfunction in our government.
We still view the negative US yield curve (currently negative 80 basis points between 2 years and 10 years and 125 basis points between 3 months and 10 years) as a contributor to a slowing economy as banks find it harder to make money borrowing short term and lending long term. Clearly that hasn’t had an effect on bigger banks, which have trading desks and myriad ways to make money away from lending. But we continue to monitor events such as layoffs, the large hangover of commercial property loans on regional bank portfolios, and high valuations in equities.
That being said, the US economy is faring better than many other places in the world. Below is the graph comparing Germany GDP and the US. It’s evident that the US is doing much better.
The relatively high level of GDP of the US combined with heightened credit concern may keep US yields somewhat higher for a longer period of time, but we think that both fixed income and equity markets reactions to this downgrade should be somewhat more subdued than 12 years ago.
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