Moody’s downgraded the US sovereign credit rating by one-notch from Aaa to Aa1 on May 16, aligning with earlier downgrades by S&P in 2011 and Fitch in 2023. The historic move reflected deepening concerns over America’s fiscal trajectory, including ballooning deficits, rising interest costs, and political gridlock. The downgrade coincided with the advancement of The One, Big, Beautiful Bill in Congress, a tax-and-spending package projected to add US$3-4 trillion to the n
ational debt over the next decade.

Moody’s cited several key factors for the ratings revision. Moody’s opined that successive US administrations and Congress have failed to agree on measures to reverse a trend of large annual fiscal deficits and growing interest costs, adding that it doesn’t believe that current fiscal proposals under consideration will result in significant multiyear reductions in mandatory spending and deficits. Moody’s also expressed the view that mandatory spending, including interest expense, is projected to rise to around 78 per cent of total US spending by 2035, from around 73 per cent in 2024. Furthermore, if the 2017 Tax Cuts and Jobs Act is extended, which is the firm’s base-case scenario, it would add around $4 trillion to the federal fiscal primary deficit, which excludes interest payments, over the next decade.

Immediate Market Reaction

The decision by Moody’s didn’t come as much of a surprise. The company in November 2023 had cut its outlook on the U.S. credit rating to negative from stable, a move that’s often a precursor to a downgrade. Consequently, investors had been weighing the potential consequences of the US losing its last triple-A rating ever since.

Nevertheless, following the downgrade, Treasury yields rose across the curve: the 10-year yield approached 4.6 per cent, while the 30-year yield surpassed 5 per cent for the first time since late 2023. The increase in yields reflected investor concerns about the US fiscal outlook and the potential for higher inflation.

Despite the downgrade, US Treasury securities remain in high demand due to their liquidity and the US dollar’s status as the global reserve currency. However, the higher yields indicate that investors may be demanding greater compensation for the perceived risks.

Should Bond Investors Be Concerned?

In the immediate term, the impact on bond investors may be limited. Treasury securities continue to be viewed as safe assets, and the US dollar maintains its reserve currency status. As such, major institutional investors (central banks, pension funds, and sovereign wealth funds) are unlikely to divest from Treasuries simply due to a one-notch downgrade. However, the increase in yields could lead to higher borrowing costs across the economy, affecting everything from mortgages to corporate bonds.

Long-term, the downgrade underscores the importance of fiscal discipline. If deficits continue to grow unchecked, the US may face higher borrowing costs and reduced investor confidence. This could, over time, place downward pressure on bond prices, particularly for longer-duration instruments. Bond investors should therefore monitor fiscal policy developments and consider the potential for increased volatility in the bond market.

In summary, Moody’s downgrade of the US credit rating highlights significant concerns about the nation’s fiscal health. While the immediate impact on bond investors may be muted, the long-term implications warrant attention. Investors should stay informed about fiscal policy developments and be prepared to adjust their portfolios in response to changing market conditions.

Eugene Stanley is vice-president, fixed income & foreign exchange at Sterling Asset Management. Sterling provides financial advice and instruments in US dollars and other hard currencies to the corporate, individual, and institutional investor. Visit our website at www.sterling.com.jm

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Eugene Stanley.