Fitch Ratings delivered a potentially humiliating blow to America’s financial reputation late Tuesday, lowering the country’s coveted triple-A credit rating and issuing a scathing indictment of its political processes, its fiscal management and its long-term debt prospects.
The only trouble is, none of Fitch’s assessments really matter to global investors and won’t have any impact on the issues the ratings company raised nor market demand for the trillions in Treasury securities that underpin the world’s financial system.
Fitch lowered its long-term U.S. debt rating by one notch late Tuesday, to AA+ from AAA, noting that Congressional standoffs over the country’s $31.4 trillion debt ceiling, “along with several economic shocks as well as tax cuts and new spending initiatives” will likely lead expanded deficits and a heavier debt-servicing burden for the country and its taxpayers.
Higher Federal Reserve interest rates, a weakening economy and stubborn inflation will compound these conditions, Fitch said, adding that the government “lacks a medium-term fiscal framework, unlike most peers, and has a complex budgeting process.”
“Additionally, there has been only limited progress in tackling medium-term challenges related to rising social security and Medicare costs due to an aging population,” the ratings company added.
Treasury Secretary Janet Yellen, predictably, hit back at the decision, noting she “strongly disagrees with an assessment she called “arbitrary and based on outdated data.”
“Treasury securities remain the world’s preeminent safe and liquid asset, and… the American economy is fundamentally strong,” Yellen said in a statement.
Former Treasury Secretary Larry Summers was even more blunt, calling the Fitch downgrade “bizarre and inept” in the face of an improving economy.
To underscore that point, investors largely fled to the safety of the very same Treasury bonds that were downgraded in the hours following Fitch’s after-market announcement Tuesday, with benchmark 10-year Treasury bonds falling 3 basis points lower — meaning prices were moving higher — to 4.013% in early New York trading.
Maybe the important thing to realize is that when it comes to sovereign debt, rating agencies have no inside information (and a lousy track record). Remember when S&P downgraded America in 2011? Neither do I 4/
— Paul Krugman (@paulkrugman) August 1, 2023
The U.S. dollar index, which tracks the greenback against a basket of six global currencies, was little-changed at 102.242 while 2-year Treasury yields slipped to 4.858%.
Yellen’s defense, while political in nature given her position within the Biden administration — and early Republican attempts to characterized the Fitch downgrade in electoral terms — is nonetheless echoed by both current fact and investor perceptions.
The Atlanta Fed’s GDPNow tool, a real-time tracker of economic growth, suggests the U.S. is growing at a 3.5% clip, following on from stronger-than-expected gains of 2.4% over the three months ending in June and the 2% pace notched over the first quarter of the year.
Recession risks are fading, with Goldman Sachs recently cutting the chances of a U.S. contraction over the next twelve months to just 20%, and the Fed has been able to raise interest rates by more than 5% over the past year without harming either consumer spending or the nation’s unemployment rate, which sits near a 50-year low of 3.6%.
The $51 trillion market for Treasury bonds themselves, in fact, underpin much of the global financial market pricing system by providing what is essentially a proxy for a ‘risk free’ interest rate.
There Is No Alternative
Nearly all of financial markets mathematics is based on the idea of such a rate, as it plays a crucial factor in the mechanics of calculating the present value of future cash flows, and the only way to remove U.S. Treasury bonds from that pivotal role would be to find a suitable replacement.
And there is none.
The European Union might be the biggest economic bloc in the world, with more than 300 million people and nominal GDP of around $4.14 trillion, but its bond market is a byzantine mixture of credit ratings, ranging from Italy’s triple-B to Germany’s triple-A.
It’s also beset with breakup risks, as evidenced by debt crisis in Greece, Portugal, Spain and Cyprus over the past decade along.
China’s $20.9 trillion sovereign debt market is also replete with issues that make it impossible to be considered as a realistic alternative to U.S. Treasuries, including a gaping lack of fiscal transparency, an autocratic government and the kind of liquidity you might find on a rainy day at a local swap meet.
And we can also forget Japan, where around half of the $11 trillion stock of government bonds are currently in the possession of the Bank of Japan, which controls day-to-day pricing of its benchmark paper and has no plans — in this life or any other — to sell them back into the market.
And we likely won’t need to wait that long to test this TINA — There Is No Alternative — thesis, either, as the Treasury prepares to unveil its quarterly plans for new debt issuance later today.
Analysts expect Yellen and her colleagues will look to sell around $102 billion in new paper over the coming quarter, up from $96 billion over the previous period, meaning larger government bond auctions over the coming weeks and months.
Indirect bidders in those auctions, which typically represent foreign central bank buyers, will be key to understanding the impact — if any — on the Fitch downgrade. And with all the talk of “dedollarizing” in global financial markets, indirect bidders still comprise between 60% and 70% of a typical Treasury auction, compared to around 30% to 40% when Standard & Poor’s first cut the U.S. debt rating to AA in 2011.
More than 68% of a $42 billion auction of 2-year notes in late May, in fact, was sold to foreign buyers, the most since 2009, even as the U.S. was locked in a debt ceiling standoff that some suggested could lead to near-term default.
The next major auction, a $37 billion sale of 10-year notes, is slated for Wednesday August 9.
America’s longer-term debt prospects aren’t pretty: paying for the borrowing needed to keep the economy ticking over has risen 25% so far this year, to just over $650 billion, and the non-partisan Congressional Budget Office says that figure will continue to rise.
And by 2033, the CBO says, overall debt to GDP, a key ratio for pegging borrowing to growth, will soar to a record 119% from its current level of around 98%.
But without a credible alternative, none of those figures will matter, either. Foreign investors will continue to fund America’s deficit spending with Treasury purchases and big export economies like China will continue to swap the dollars they earn in trade for interest-bearing securities that carry no risk.
And the letter grades assigned to those securities simply won’t mean a thing.
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