Fitch’s lesson to Biden’s America
Fitch's downgrade of the United States is a reminder that rising deficits can come at a cost. The analysis of Mike Cudzil, Portfolio Manager of PIMCO
For the second time in 12 years, one of the top three credit rating agencies has stripped the US government – the world's largest sovereign debt issuer – of its highest ever triple-A credit rating. While this week's move by Fitch Ratings is symbolically significant and has practical implications for markets as well, we don't expect it to trigger a massive sell-off in US Treasuries or any short-term change in investor behavior.
We also do not believe the downgrade reflects any relevant new information about the strength of the US government. Treasuries continue to be considered the benchmark, risk-free asset class, and serve as a benchmark for financial markets around the world. We also do not expect the downgrade to affect the size or speed of the Federal Reserve's rate-hiking cycle in its fight against inflation.
We are currently broadly neutral on US duration, a measure of interest rate risk, and will continue to adjust duration positioning based on our fair value range.
Rating downgrade. The return
On August 1, 2023, Fitch cut the US sovereign rating by one notch from AAA to AA+, citing three main factors:
- Expected fiscal deterioration over the next three years
- A high and growing public debt burden
- The erosion of governance relative to peer ratings over the past two decades, which has manifested itself in repeated debt ceiling stalls and last-minute resolutions.
Fitch warned in May that a US downgrade could be imminent, even if that comes before Congress reached a debt ceiling deal in June.
In 2011, another credit rating firm, S&P Global Ratings, similarly stripped the United States of its top rating of triple-A following a deadlock on the US debt ceiling. Interestingly, the then downgrade led to increased investor demand for US Treasuries, driving yields lower, reflecting the perception of Treasuries as the asset class of choice in times of economic uncertainty.
Moody's, the third major rating firm, maintains triple-A ratings for US sovereign debt.
Economic and political impacts
Despite widespread predictions of a weakening US economy this year, the timing of the downgrade is noteworthy as recent data has raised questions about the likelihood of a US recession. Recent data, culminating in a stronger-than-expected second-quarter GDP report, suggests that the US economy is proving more resilient than expected as the Fed hikes rates and easing inflationary pressures.
We continue to believe that the US economy will slow in the second half of 2023 due to stalling bank lending, lagged monetary policy effects and headwinds of a fiscal nature. However, with the initial growth momentum now looking stronger and the banking sector headwinds potentially abating, the likelihood of a near-term recession also looks lower.
Even before the downgrade, we expected a limited appetite for further tax expenditures, regardless of economic conditions. More generally, we believe that over the next five years, given the current level of sovereign debt relative to GDP, fiscal capacity will be more constrained than in the past – both by politics and financial markets – and will limit the ability of fiscal policy to smooth future economic downturns.
Impacts on the market
The Fitch downgrade is another reminder that risks related to deficit spending and debt sustainability, which tend to remain dormant, can emerge and cause concern. This creates the potential for surprises and market volatility, especially given the diminishing capacity for fiscal and monetary support.
In the long run, this could lead to a weaker dollar, higher bond yields and steeper yield curves. Last year's liability-driven investment (LDI) crisis in the UK was a similar reminder that concerns about fiscal stability can arise quickly and that the UK could be a canary in the long-term fiscal coal mine. term.
To help finance the surge in US loans, the US Treasury said this week it would increase the amount of quarterly bond sales for the first time in more than two years. This could become another source of concern for investors and could potentially drive up bond yields.
For now, volatility may benefit investors who remain flexible and are able to seize opportunities when market valuations overshoot. While rating agency ratings and opinions are important, we at PIMCO are constantly conducting our own credit research. We recognize improving US economic data in our portfolio construction, but focus on assets that are resilient in the face of ongoing macroeconomic risks and uncertainty.
This is a machine translation from Italian language of a post published on Start Magazine at the URL https://www.startmag.it/economia/lezione-fitch-stati-uniti/ on Sun, 06 Aug 2023 05:00:23 +0000.