Last week, Moody’s downgraded the U.S. credit rating from Aaa to Aa1, joining the other two major credit rating agencies, S&P Global and Fitch, in lowering the U.S. one notch below perfect. S&P Global downgraded the U.S. in 2011 and Fitch did so in 2023.
What does the downgrade mean?
In absolute terms, not much. There are about $29 trillion of Treasury securities outstanding and over $900 billion Treasuries traded every single day. The enormous size of the market creates network effects that make it nearly impossible to participate in global commerce without Treasuries and dollars. The knock in credit rating is largely a non-event for the Treasury market and it does not change risk-weighted models for institutions or regulators. For now, U.S. Treasury notes, bills and bonds will continue to underpin the global financial system (as will the U.S. dollar, more on this later) and still be considered of the highest quality collateral available in the marketplace.
However, there are risks.
The U.S. debt is now over $36 trillion, and the debt-to-GDP ratio is approximately 124%. It’s beyond the scope of this post to debate optimal government debt levels and monetary theory so let’s skip to the end and conclude there is a limit to the effectiveness of debt when pursuing economic growth.
When the government borrows more and more it reduces available resources and crowds out private investment. On net, the Congressional Budget Office (CBO) estimates private investment falls by 33 cents for every dollar the federal deficit increases.
Rising interest rates and borrowing costs consume even more resources which can suffocate government and private sector balance sheets.
Inflation is the most obvious risk to unchecked debt and fiscal spending. See Venezuela.
Fear of currency devaluation and dollar debasement take center stage every time the U.S. debt level reaches new heights. It makes sense, the U.S. issues debt in its own currency which is also the global reserve currency. Any real crisis of confidence around the U.S. dollar would have far-reaching ramifications.
To push back on the dollar debasement argument, consider the dollar accounts for nearly 60% of global reserves. The Euro is the next largest reserve currency at just under 20%. Bloomberg reported the dollar’s share of worldwide payments climbed to 50.2% in January. Their chart is below. Couple this with data showing the U.S. dollar is used in almost 90% of foreign exchange transactions.
Maybe a day will come when a viable alternative to the dollar emerges. Keep in mind that alternative will have to be a proven store of value, an effective unit of account and a frictionless medium of exchange. Also, the depth of market liquidity and convertibility are an absolute must. For these reasons, it’s hard to see the dollar’s demise as imminent.
An additional risk worth mentioning is the burden future generations potentially face if the U.S. does not find a more sustainable fiscal and monetary path. By transferring a disproportionate amount of the cost of today’s consumption to tomorrow, we are risking future economic opportunities.
Where do we go from here?
As it relates to Treasuries, we still like the middle of the curve right now (3, 5 and even 7 years) as they should continue to present attractive yields while limiting duration risk compared to the longer end of the curve like 10- or 30-Year Treasuries. Duration measures the interest-rate risk of a bond. It is the change in value of a bond for a 1% change in interest rates.
Ultimately, we don’t anticipate much from the Moody’s downgrade, but we do expect pockets of volatility to emerge from the confluence of fiscal, monetary and trade policy. This should create opportunities within a well-diversified portfolio.