Moody’s Downgrade Just a Trigger for Stock Pullback — But Here’s What Really Matters

The sudden downgrade by Moody’s could dampen the rally mood, as U.S. Treasuries are no longer viewed as a symbolic 'safe-haven asset.' This may trigger a valuation reset, especially with the S&P 500 in a technical bull run since the April bottom, fueled by investor greed to ride the surge. Based on the past two downgrades, the market tends to experience an average chaotic pullback of around 10% before eventually recovering and entering another bull phase. But more importantly, this isn’t just about the downgrade. Here are the key elements to watch.

Prior to Moody’s action, the market was already in a bull frenzy. The S&P 500 had surged 23% in a month, fueled by Trump’s trade deal with the UK, a temporary tariff lift with China, and multi-trillion-dollar investment commitments from the Middle East. These moves were widely seen as a win for Trump’s strategy, and investors believed they would ultimately benefit the U.S. economy—despite inflation risks and a global baseline tariff of 10%. As discussed in our last article, FOMO-driven momentum pushed the market into extreme bullish territory.

To be specific, the S&P 500 closed at 5,958 on Friday, just under a key psychological barrier. Breaking through this level would require new catalysts, such as further trade deals or renewed hopes for rate cuts. Meanwhile, the RSI hit 88.59—levels not seen since July 10—signaling overheated bullish sentiment. These conditions alone posed a risk for a pullback, and Moody’s downgrade simply served as the trigger.

Looking at history, the downgrade of U.S. sovereign credit has had severe short-term consequences. On August 5, 2011, S&P cut the U.S. long-term rating from AAA to AA+ with a negative outlook, citing dysfunctional policymaking (i.e., bipartisan gridlock on debt governance) and doubts over medium-term debt sustainability. The S&P 500 plunged 6.66% in a single session and took two months to fully recover before resuming its uptrend.

Then came another downgrade two years ago. On August 1, 2023, Fitch also cut the U.S. credit rating from AAA to AA+, citing a ballooning debt burden and deteriorating fiscal health. The S&P 500 fell 1.38% the next day and experienced an almost 10% correction before hitting new highs four months later.

So, is the credit downgrade a big deal? Initially, yes. It can spook investors and force some large funds to sell Treasuries due to the loss of AAA status, pushing yields higher and pressuring equities. But in the longer term, once the fear fades, investors typically shift back to fundamentals and resume buying. Meanwhile, the dollar remains dominant in global trade and commodities—underscoring continued confidence in U.S. credit. Despite losing its elite rating, the dollar is still the world’s reserve currency. Investors ultimately have no choice but to play in this system.

But here’s what really matters: President Donald Trump may further weaponize tariffs, especially after securing early deals in the Middle East. On Friday, Trump acknowledged his administration lacks the capacity to negotiate individually with all nations affected by his sweeping reciprocal tariffs plan. As a result, Treasury Secretary Scott Bessent and Commerce Secretary Howard Lutnick will begin sending letters to U.S. trading partners, notifying them of specific tariff rates they’ll face.

In parallel, Bessent said on Sunday that tariffs will return to “reciprocal” levels if trade agreements aren’t reached during the current 90-day pause—stating that many countries are not negotiating “in good faith.” So far, deals have only been made with the UK and temporarily with China (with a 34% tariff still applied to Chinese imports). Investors are hungry for more agreements, especially with inflation risks expected to reemerge in May.

Rising prices could complicate the Fed’s path forward. Chair Jerome Powell has shown reluctance to cut rates and prefers a wait-and-see approach. Yet, keeping rates high forces the Fed to pay more interest on Treasuries, worsening the fiscal deficit. This could undermine Trump’s broader ambition. Lower Treasury yields would help ease the deficit burden and fuel corporate financing and growth—feeding into his “Make America Great Again” narrative.

Adding another layer of complexity is Trump’s proposed tax cut, aimed at boosting domestic manufacturing. Combined with tariff threats, it seeks to attract more corporate investment into the U.S. But as Moody’s noted, these tax cuts could deepen the fiscal hole. With the deficit-to-GDP ratio already at 9%, debt is projected to reach 134% of GDP by 2035. It’s starting to look like a closed loop—tariffs, taxes, interest rates, and debt all feeding into each other. While some downplay the current debt levels, the risk grows if the tax cuts are officially enacted.

This may explain why Warren Buffett has exited many positions in recent years. He may view the ballooning debt as a ticking time bomb. As he said during the Berkshire Hathaway shareholder meeting: “We're operating at a fiscal deficit now that is unsustainable over a very long period of time.”

Still, the U.S. debt crisis may remain distant for now, as dollar dominance and a rising debt ceiling could temporarily ease the pressure. However, if Trump fails to secure more deals, escalates tariffs, delays rate cuts, and moves forward with massive tax cuts, these could become key triggers dragging the market further down.