Moody's Downgrades US Credit Rating, Markets React With 0.9% Drop

U.S. financial markets have been surging since President Donald Trump has paused or rolled back some of his tariffs. The United States' long-held triple-A credit rating was downgraded by Moody’s Ratings, sparking a wave of investor unease and market volatility. The downgrade to Aa1 from AAA was attributed to a deteriorating fiscal trajectory and a lack of effective policy action to address rising deficits. This move by Moody’s, the last of the major rating agencies to maintain the US at the highest rating, has shifted investor focus back to the structural weaknesses in US fiscal policy.

The immediate market reaction was significant, with futures tied to the Dow Jones Industrial Average dropping 291 points, or 0.7%, while S&P 500 futures fell 0.8% and Nasdaq 100 futures declined 0.9%. This early response reflected investor concerns about the potential ripple effects on bond markets and broader asset pricing. The downgrade comes at a time when the US is already grappling with rising borrowing costs, with 10-year Treasury yields touching 4.49% and the 30-year yield poised to rise above 5%, levels not seen since 2007.

Analysts have warned of a potential "dangerous bear steepener spiral," where investors begin selling longer-dated US debt, forcing yields higher and potentially putting downward pressure on the dollar and equities. Max Gokhman, deputy CIO at Franklin Templeton Investment Solutions, highlighted that debt servicing costs will continue to rise as large investors, both sovereign and institutional, start gradually swapping Treasuries for other safe haven assets. Although a weaker dollar can sometimes support exports, the current sentiment has shifted markedly, with options traders now the most bearish on the greenback in recent years.

The US Treasury Secretary Scott Bessent downplayed the significance of the downgrade, calling Moody’s a “lagging indicator” and reaffirming the administration’s commitment to spending restraint and economic growth. However, Moody’s warned that the US budget deficit, now nearing US$2tn annually—or over 6% of GDP—could widen further to nearly 9% by 2035. The Congressional Budget Office had previously estimated US debt would exceed 107% of GDP by 2029, surpassing post-World War II levels. Despite these projections, Moody’s noted that there are no material multiyear reductions in mandatory spending or deficits under current proposals.

The downgrade has also raised concerns about geopolitical risks, with President Trump citing hopes to reduce tensions over the war in Ukraine during a planned call with Russian President Vladimir Putin. The ongoing work on a new tax-and-spending bill could add another US$3.8tn to the federal debt over the next decade, with independent analysts warning the true cost could be much higher if temporary provisions are extended.

While the downgrade is symbolically significant, many analysts downplayed the likelihood of lasting market disruption. Barclays strategists noted that similar downgrades in 2011 and 2023 had only limited consequences. Toby Nangle, formerly of Columbia Threadneedle, echoed that view, noting that banks are unlikely to face higher capital requirements from the downgrade, since regulators do not differentiate between AAA and AA1 for risk-weighting. However, there are signs of increased investor caution, with gold edging up and early currency markets showing the US dollar slightly weaker against the euro and yen.

Carol Schleif, chief market strategist at BMO Private Wealth, noted that the bond market remains acutely focused on Washington’s fiscal wrangling. Some observers pointed out that concerns about default remain largely academic, given the US government issues debt in its own currency. Stephen Innes, managing partner at SPI Asset Management, highlighted that the US Treasury bond is one of the least likely assets to default, as the central bank can conjure up settlement liquidity with a keystroke.

Despite these reassurances, with yields rising and deficits deepening, investors may face another volatile start to the week as confidence in the long-term stability of US finances is put to the test once again. The market's reaction to the downgrade underscores the ongoing concerns about the US fiscal outlook and the potential for further market volatility in the coming days.