Debt Downgrade Explained

On August 1st, the credit rating agency Fitch downgraded the sovereign debt of the United States from AAA to AA+.

Fitch is one of three credit rating agencies that also includes Moody’s and Standard and Poor’s. In some respects, downgrading debt issued by the U.S. Treasury is total nonsense, but in other ways, it is a logical response to the merest thought that the Treasury could even temporarily miss an interest payment.

Explaining its rationale for the downgrade, Fitch expects “fiscal deterioration over the next few years, a high and growing debt burden, and the erosion of governance relative to AA and AAA peers over the last two decades that has manifested in a repeated debt limit and last-minute resolutions”. A large part of their rationale is based on the forecast of a recession beginning in a few months. A recession that economists have been predicting for the last 18 months.

Fitch does point out that the downgrade is not about the government’s ability to pay, but its willingness to service its debt. There is no doubt we have big fiscal challenges ahead and drama over increasing the Treasury debt limit is frustrating and inappropriate, but we are not concerned about the US Treasury servicing its debt. No matter how dysfunctional Congress seems to be, it is hard to imagine any treasury secretary wanting to be remembered as the person at the helm when the U.S. Treasury missed an interest payment. It is also hard to imagine any person in Congress letting this happen and it is unfortunate that the threat of default is being used as a bargaining chip.

There is no question in our mind that U.S. Treasuries are AAA. Moody’s agrees and still rates U.S. debt AAA. The rating agencies can do whatever they want, but it is the market that speaks, and the Treasury’s interest cost remains incredibly low. Microsoft and Johnson & Johnson are the only two AAA corporate credit ratings in the U.S. Their 30-year bonds yield 4.88%, whereas the U.S. Treasury’s 30-year bond yields 4.27%. The Fitch downgrade simply reflects the political issues that are impacting agreements to slow the growth of government spending relative to GDP. Nonetheless, there is no substitute for U.S. Treasuries, and they remain the safest and most liquid asset in the world.

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