During the lead up to the US congress’ decision on whether to raise the debt ceiling or not, Fitch made a release putting the US on their negative watch list. This implies that the US debt instruments coming due in the coming months are in danger of going unpaid, a first in US’ financial history should it happen. This increased probability of US’ “AAA” rating becoming downgraded prompted Fitch to update their outlook using their proprietary scorecard methodology, the components of which (like for other ratings agencies) are publicly available but how that information is processed into a country score is anyone’s guess.
Ratings agencies typically rely on publicly available quantitative data to provide scoring for countries, such as National Accounts like GDP, Imports, etc., which goes through rigorous statistical testing and mathematical transformations for it to become the score that they publish. However, given the sensitive nature of National Accounts to events, these scorecards usually have separate Early Warning Signal as an attempt to include qualitative analysis as an adjustment to the score. In this case, the Early Warning Signal was triggered by the negative news surrounding US’ debt ceiling woes. If lawmakers fail to raise the borrowing limit before the Treasury runs out of funds, a downgrade could become a reality, impacting the pricing of trillions of dollars in Treasury debt securities.
This development evokes memories of 2011 when a similar downgrade by S&P triggered a stock market sell-off that took six months after to recover. Interestingly, following the S&P downgrade, interest rates on Treasuries experienced an unexpected decline. This counterintuitive trend emerged as investors sought the safety of the most secure assets available, leading to heightened demand for US Treasuries. The increased demand exerted downward pressure on interest rates, allowing the issuer to offer lower returns while still attracting buyers and kept borrowing costs from rising. Does that imply that a Fitch downgrade may not be so bad at this time?
Most certainly not, the US bouncing back from that downgrade 12 years ago happened in tandem with a financial crisis in Europe lessening the options investors have for “safe” havens for their investments and the Fed was not aggressively battling inflation at that time, unlike today. As the Fed paused interest hikes for this month’s FOMC, this would give the current level of US interest rates and CPI the time to catch up with each other before they decide on keeping this hawkish stance in the coming months. This combination of rising borrowing costs and a possibility of a downgrade is quite dangerous as capital flight from the US economy is unprecedented. Should this trend of political instability keep going and Fitch does decide to pull the trigger and downgrade the US amidst the current economic scenario it may lead to other economies waiting in the wings (mostly just China) to aggressively attempt to crowd out (or snap up) US Treasuries to give them a chance to recover the economic power they’ve lost due to the COVID-19 pandemic.
Now that we’ve laid out how wrong things could possibly go for the US if it is downgraded again in 2023, what would it take for the US to avoid staying on Fitch’s negative watch list? As mentioned earlier, the US being put on a negative watch list is based on Fitch’s internal definitions in their Early Warning Signals on the back of the negative news surrounding the US debt ceiling discussions. Now all the US has to do is showcase political stability in the coming months and that the Fed, US Treasury, and US congress will successfully manage the US’ increasing debts – easy peasy.