Fitch Ratings recently reduced the US government’s credit grade from AAA to AA+. The agency cited the nation’s troubling fiscal forecast as a major factor behind this decision. The downgrade took place against the backdrop of debates over increasing the debt limit and predictions of financial deterioration in the next three years due to tax cuts, fresh spending initiatives, economic turbulence, and recurring political standoffs.
Following the downgrade, Moody’s Investors Service remains the only major rating agency still assigning the US sovereign debt its highest rating, Aaa.
What Are the Fitch Credit Ratings?
Fitch Ratings is one of the three major global credit rating agencies, the other two being Moody’s and Standard & Poor’s. These agencies evaluate the creditworthiness of entities such as businesses and governments, and the credit quality of their debt issues.
Credit ratings are used by investors to assess the risk of default on debt, and they influence the interest rates that entities must pay to borrow money. A higher rating indicates a lower risk of default, and thus a lower interest rate, while a lower rating indicates a higher risk of default and a higher interest rate.
Fitch Ratings provides international credit ratings, employing a scale from ‘AAA’ (the highest) to ‘D’ (default). Here’s a basic overview of Fitch’s credit rating scale:
- ‘AAA’ ratings denote the lowest possible risk of default. Entities with this rating are considered to have an extremely strong capacity to meet their financial commitments.
- ‘AA’ ratings denote a very low default risk, slightly more so than ‘AAA’ entities. The capacity to meet financial commitments is very strong.
- ‘A’ ratings denote a low default risk. The capacity to meet financial commitments is strong, but the rating is somewhat more susceptible to adverse economic conditions.
- ‘BBB’ ratings denote a moderate default risk. They represent the lowest rating category considered investment grade. Adverse economic conditions are more likely to weaken this capacity.
- ‘BB’, ‘B’, ‘CCC’, ‘CC’, and ‘C’ ratings denote a higher default risk. They are considered speculative grade, with ‘BB’ being the least and ‘C’ being the highest risk within this group.
- ‘D’ rating is assigned when an entity has defaulted on a financial commitment.
Each rating from ‘AAA’ to ‘CCC’ can be modified by a plus (+) or minus (-) sign to show relative standing within each category.
Remember, credit ratings are not absolute measures of default probability. They are relative rankings of credit risk, and while they can be useful tools for investors, they should not be the sole factor in any investment decision. As the 2008 financial crisis showed, even highly-rated securities can still carry significant risk.
Why the Drop?
This fiscal year’s first nine months saw the US federal deficit surge to $1.39 trillion, a hefty 170% increase from the previous year’s same period. As a result, the Treasury boosted its borrowing forecast for the current quarter to $1 trillion, exceeding its May prediction of $733 billion. Fitch states,
“The rating downgrade of the United States reflects the expected fiscal deterioration over the next three years, a high and growing general government debt burden, and the erosion of governance…In Fitch’s view, there has been a steady deterioration in standards of governance over the last 20 years, including on fiscal and debt matters, notwithstanding the June bipartisan agreement to suspend the debt limit until January 2025,”
The downgrade stirred political debates, with Democrats accusing Republicans of hindering the earlier increase of the debt ceiling, while the GOP attributed the downgrade to ‘Bidenomics’ – a phrase commonly used when referring to President Biden’s spending plans.
Response and Commentary
US Treasury Secretary, Janet Yellen, responded with strong criticism of Fitch’s move, calling it “arbitrary” and “outdated”. Yellen pointed to recent signs of economic stability and the eventual raising of the debt limit as reasons for her dissent. In similar fashion, Allianz SE’s chief economic adviser, Mohamed El-Erian, questioned the timing of the downgrade, expressing skepticism about its influence on investors.
Interestingly, the bond market reacted mildly to the downgrade. While a rating downgrade often results in a decrease in bond prices, the yield on 10-year Treasury bonds remained relatively unchanged. Meanwhile, the equivalent rate on German securities experienced a slight dip. Risk-sensitive assets didn’t fare as well, with Europe’s Stoxx 600 Index seeing its most significant drop in a month.
Fitch’s downgrade may also complicate matters for funds or index trackers strictly invested in AAA-rated securities, potentially leading to compulsory sales for compliance.
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