Moody's Downgrades U.S. Credit Rating, Citing Fiscal Concerns

JPMorgan strategists, including Jay Barry, have warned that Moody's downgrade of the U.S. credit rating could lead to increased interest costs in the long term. This move is expected to make U.S. Treasuries less attractive compared to overnight index swaps (OIS) of matching maturities. The strategists noted that the structural shift in demand dynamics, coupled with uncertainties in trade and monetary policy, could lead to a bearish trend in the short term. However, the volatility resulting from this event is likely to be less severe than that following the "Liberation Day" tariff announcement in early April, as investor positions are now more neutral and less prone to market overreactions.

The report also suggests that, all else being equal, Moody's one-notch downgrade could narrow the 30-year swap spread by about 5 basis points. However, U.S. Treasuries already exhibit a higher risk premium compared to similar-rated sovereign debt from other developed markets, indicating that the price reduction may be less than what these coefficients suggest.

Moody's decision to downgrade the U.S. credit rating from Aaa to Aa1 reflects growing concerns over the country's fiscal sustainability. The U.S. federal debt has surpassed 36 trillion, with a budget deficit exceeding 6% of GDP. This financial strain has raised alarms about the U.S.'s ability to maintain its fiscal health, potentially leading to higher borrowing costs and increased financial market volatility. The downgrade also underscores the challenges posed by the U.S.'s expanding debt and deficit, which could erode the dollar's status as a global reserve currency and impact emerging markets.

Moody's downgrade is the latest in a series of actions by major credit rating agencies, following similar moves by Fitch and Standard & Poor's. The agency cited the U.S. government's failure to address its fiscal imbalances, which have been exacerbated by large-scale borrowing to fund pandemic relief and other spending initiatives. The downgrade reflects Moody's assessment that the U.S.'s economic and financial strengths are no longer sufficient to offset the potential decline in its fiscal indicators.

The U.S. federal debt has reached 36.2 trillion, surpassing the congressionally mandated debt ceiling of 36.1 trillion. This includes 28.8 trillion in public debt and 7.3 trillion held by foreign entities. The Congressional Budget Office has warned that the U.S. federal debt could exceed post-World War II levels within four years, reaching 107% of GDP by 2029. The rising debt is accompanied by a widening budget deficit, which is projected to reach nearly 2 trillion by 2025, or more than 6% of GDP. Economists warn that the global trade war could further weaken the U.S. economy, exacerbating the deficit as government spending typically increases during economic slowdowns.

Moody's assessment highlights that the rising debt levels and interest payments are straining the U.S. fiscal sustainability. With interest rates hovering between 4% and 5%, similar to pre-financial crisis levels, the U.S. faces significant challenges in managing its debt. Moody's projects that the federal deficit will widen to nearly 9% of GDP by 2035, driven by increased interest payments, welfare spending, and relatively low fiscal revenue. The agency also acknowledges that much of the U.S. debt was incurred to mitigate the economic impact of the pandemic, but this has led to an overall debt level that exceeds the country's economic output.

The U.S. Treasury Secretary, Janet Yellen, has acknowledged the unsustainable trajectory of the U.S. debt, describing the numbers as "frightening" and warning of a potential economic crisis if credit dries up. However, she has also assured lawmakers that such a scenario is unlikely. The administration has been working to address the fiscal challenges through measures such as tax cuts, regulatory reductions, and tariffs aimed at boosting manufacturing and reducing the trade deficit. These efforts are part of a broader strategy to enhance economic growth and reduce the reliance on foreign borrowing.

The U.S. Treasury's recent data shows that federal revenue grew by 10% year-over-year in April, while spending decreased by 4%. Notably, tariff revenue surged by 130% to 16 billion, setting a new record and helping to alleviate fiscal imbalances. The federal surplus for April reached 258.4 billion, a 23% increase from the previous year, reflecting strong tax revenue growth and increased tariff income. These figures suggest that the economic impact of tariffs may be more positive than initially anticipated, although further observation is needed to assess their long-term effects.

Moody's downgrade of the U.S. credit rating has significant implications for the U.S. economy. The downgrade could increase the federal government's borrowing costs, as investors may demand higher yields to compensate for the perceived risk. This could lead to higher interest payments on new debt issuances and refinancing of maturing debt, potentially adding tens of billions of dollars to annual interest expenses. At the enterprise and consumer levels, rising Treasury yields could push up overall market interest rates, affecting corporate borrowing costs and consumer credit rates, thereby dampening investment and consumption.

The downgrade could also trigger market volatility, particularly in stock and bond markets. Investors may reassess their asset allocations, leading to short-term selling or increased risk aversion. For instance, some investors might sell equities due to concerns about economic prospects, exacerbating market volatility, especially in high-valued sectors like technology. In the bond market, Treasury prices could fall, and yields could rise, but given the U.S. Treasury's status as a global safe-haven asset, significant selling is less likely in the short term.

The U.S. dollar's status as the world's primary reserve currency could face minor challenges, but its long-term dominance is unlikely to be threatened. The downgrade could also impact investor confidence and the U.S.'s international standing. Losing the AAA rating from all three major rating agencies could weaken the U.S.'s image as the most reliable borrower, reducing the attractiveness of its financial markets. Foreign central banks and institutions might decrease their demand for U.S. Treasuries, particularly in emerging markets, which could accelerate the diversification of reserve assets. The downgrade could also be interpreted by some countries as a sign of U.S. economic hegemony in decline, eroding its soft power in the global economy.

The downgrade reflects concerns about the U.S.'s fiscal trajectory, including rising debt-to-GDP ratios and increasing interest payment burdens. The federal government may face greater pressure to control the deficit, but partisan divisions could hinder effective fiscal reforms, such as spending cuts or tax increases. If borrowing costs rise, the federal government might need to issue more debt to cover interest payments, creating a vicious cycle. Persistent fiscal deterioration could lead to further downgrades, exacerbating economic pressures.

The downgrade of the U.S. credit rating could have broader global implications. As U.S. Treasuries are considered one of the safest investments worldwide, a downgrade could trigger a chain reaction in global financial markets, especially given the lingering risks of a global debt crisis. In the coming weeks, it remains to be seen how this will affect global stock and bond markets. For emerging markets, higher dollar funding costs could exacerbate debt pressures, leading to capital outflows or currency depreciation. Globally, countries might further reduce their reliance on dollar assets, accelerating the de-dollarization process, although this trend is unlikely to accelerate significantly in the short term.