Last week, Moody’s, one of the leading credit rating agencies, downgraded its rating on US sovereign debt by one notch – on a 21-notch scale! – from Aaa to Aa1. We wanted to dig into this in a bit more detail.
Rating agencies have traditionally held a bit of a hybrid role in the financial system. They are private companies and do the same analysis that many other financial institutions do. But it’s still a signal and ratings agencies have historically had greater sway, not least because many investors are required to consider their ratings when deciding what instruments they can potentially buy. So, in theory, a downgrade from one of the major ratings agencies might carry more weight than you’d expect. And we did see the cost of borrowing rise for the US government after the announcement.
But it’s worth noting that that hasn’t always been the case. Another major ratings agency, S&P, downgraded US debt from its highest level back in 2011, while the third, Fitch, did the same in 2023. In the past, investors have generally looked past the ratings downgrades and bond yields barely reacted. If anything, Moody’s was the outlier for not having downgraded the credit rating on US debt.
Is something different this time? It’s too soon to tell, but the downgrade comes at a time when US government debt is in focus for a couple of reasons. At a headline level the federal budget deficit has been deteriorating over the past twenty-five years, as you can see in the chart below.
That has caused the overall government debt as a percentage of GDP to rise, as you can see in the chart below. The chart below also shows the current forecast from the non-partisan Congressional Budget Office, which expects debt as a percentage of GDP to rise steadily over the coming decades.
It’s also worth highlighting that the deficit has worsened at a time when the US economy has been pretty strong. The chart below illustrates the point it compares the annual deficit to the unemployment rate (the black line) and periods of recession (blue columns). As you might expect, in the past the deficit widened during periods of recession and when unemployment rose.
Over the past few years, however, we’ve seen the deficit continue to widen even though the economy was robust. That speaks to some of the structural challenges that the US government faces – challenges that Elon Musk and Doge were, in theory, trying to solve.
Interest expense has been another focus of attention. During the period of very low interest rates between 2009 and 2022, government debt rose, but the amount the government spent on interest stayed pretty low. Since 2021, however, we’ve seen debt servicing costs rise sharply. The chart below illustrates the point it shows federal interest expense as a percentage of GDP.
The final point is that the US Congress has been debating the President’s budget proposal, which looks to at least maintain the annual budget deficit going forward, and potentially increase it.
But most of this has been well-flagged for some years. Investors have generally looked past these forecasts and given the US government credit for its significant strengths – notably the large, wealthy, growing economy, and the US dollar’s status as the reserve currency. And the US is hardly alone in having higher debt to GDP. But, with higher interest costs, persistent fiscal deficits and perhaps more uncertainty around policy – investors look to be demanding a higher rate to own US government debt.
What does it mean for portfolios? Overall, this supports our slightly conservative view at present. We think government finances could come into greater focus in the coming months and not just in the US. For instance, we’ve seen bond yields in Japan continue to move higher in recent weeks.
In terms of our positioning, prior to Moody’s announcement we had reduced our exposure to longer-dated US government bonds in favour of shorter-dated euro and sterling denominated instruments. We’re comfortable with our current positioning for now, and we’ll continue to look for opportunities across the investment universe.
*As with all investing, financial instruments involve inherent risks, including loss of capital, market fluctuations and liquidity risk. Past performance is no guarantee of future results. It is important to consider your risk tolerance and investment objectives before proceeding.
