U.S. Government Debt Was Downgraded. Will it Matter?

by Lawrence Gillum, CFA, Chief Fixed Income Strategist, LPL Financial

Yesterday, one of the three main rating agencies (Fitch) downgraded U.S. government debt to its second highest rating, AA+. The agency cited “the expected fiscal deterioration over the next three years, a high and growing general government debt burden, and the erosion of governance relative to ‘AA’ and ‘AAA’ rated peers over the last two decades” as the reasons for the downgrade. The rating agency warned two months ago that a downgrade was an option and, frankly, has been warning of a downgrade for years. The two other major rating agencies have not changed existing ratings: Moody’s still has the U.S. at Aaa while S&P remains at AA+.

While not necessarily wrong in its assessment, the rating downgrade will likely not have an impact on U.S. government debt or markets broadly. The U.S. remains the safe haven during times of market stress and the downgrade will likely not change that. That was further evidenced by the (non) reaction from the bond market after the announcement. And this isn’t the first time the U.S. has been downgraded. In August 2011, S&P, which arguably carries more weight than Fitch, cut the U.S. rating from AAA to AA+, which is the current rating. At the time S&P noted that the downgrade “reflects our opinion that the … plan that Congress and the Administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government’s medium-term debt dynamics”. And while that came as an initial surprise to markets, markets recovered in short order with the S&P 500 Index rebounding and finishing up the year nearly 20% off those lows.

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A potential reason why it could matter to investors is likely only administrative. The U.S. is officially split-rated so accounts that have minimum AAA-rating requirements may have to change account documentation, but it will not likely result in forced selling. That said, continued fiscal expansion/deficits could result in additional downgrades from rating agencies. So, until the U.S. government gets its fiscal house in order, we’re likely going to see additional downgrades.

In a related announcement this week, the Treasury department seeks to borrow an additional $1 trillion in the third quarter alone (and nearly $2 trillion over the rest of the year). This is on top of the $1 trillion of new debt that has been issued since the debt ceiling was removed in June. With budget deficits expected to continue, we’re likely going to see elevated Treasury issuance as well. While historically there has been very little relationship between supply and prices, given the amount of Treasury debt coming to market over the next few quarters/years, we could see upward pressure on yields. However, we think the 10-year Treasury yield ends the year between 3.25% and 3.75%.

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