The US is becoming more of an outlier among countries with a gold-plated AAA credit rating. As its $28 trillion debt burden grows, will the rating companies continue to treat America as an exception?
The US was downgraded one step by Standard & Poor’s in 2011 to AA+, but the country still has top rankings from the other big ratings firms, Moody’s Investors Service and Fitch Ratings. The US is far out of kilter with other AAA nations like Germany, Australia, and Norway, according to Fitch data on federal debt to gross domestic product. The Senate’s latest bill will increase spending by $1.1 trillion in 2021 and nearly $500 billion in 2022, increasing debt-to-GDP to 109% this year.
One of the reasons the world’s largest economy can get away with splurging on so much debt is because the US dollar is the main reserve currency, which gives the country exceptional capacity to sell bonds that are in high demand around the world. Faith in the greenback is also backed up by sound government institutions and rule of law.
Even so, there signs the rating firms are finding it increasingly difficult to overlook the US’s eye-popping debt levels. Fitch, which put the US’s credit rating on negative outlook in July, rang the alarm again this month when it said president Joe Biden’s $1.9 trillion American Rescue Plan will push the country even further away from a stabilized debt burden. Analysts led by Charles Seville said the administration has yet to set out its full fiscal ambitions, which are expected to include another package of spending on infrastructure and some higher taxes, such as larger contributions to Social Security from higher earners. The rating firm has said the US could be downgraded without a plan to balance debt and spending “in the post-pandemic phase.”
In June, Moody’s was mostly sanguine about the US debt burden. “While the coronavirus pandemic has created unprecedented challenges for the US economy and exacerbated the pace of deterioration of the government’s fiscal position, Moody’s expects the US economy to recover over time and the sovereign’s credit profile to remain resilient to the shock,” the company’s analysts wrote. “These features currently counterbalance the US’ relatively lower and weakening fiscal strength.”
But even Moody’s had a hint of caution, pointing out that higher age-related entitlement spending and weaker tax revenue will begin to bite in the coming years.
For its part, S&P has a stable outlook on its AA+ rating for the US—one notch below AAA—which is based on the dollar’s reserve status and institutional strengths, as well as the credibility of the Federal Reserve, which helped stabilize financial markets and the global economy after the onset of the pandemic, said Joydeep Mukherji, managing director for sovereign ratings at S&P. Mukherji expects the US’s stimulus package “will sustain rapid GDP growth this year.”
“We also expect that the sovereign’s fiscal deficit will fall and its debt burden will stabilize in the coming couple of years as the economic impact of the pandemic recedes,” Mukherji said.
Should Fitch or Moody’s downgrade the US, investors will flock to US government debt instead of rejecting it, if history is any guide. That’s what happened in 2011 when S&P cut the US ranking by one step. The event sent shockwaves through global markets and investors temporarily fled riskier assets like stocks—but they embraced US Treasurys, the very asset that had just been downgraded. A similar phenomena also played out when France lost its AAA in 2012.
That reaction—a downgrade seemingly making government bonds more valuable instead of less, at least temporarily—may reflect several factors. Unlike companies, which also have credit ratings, countries can print money if needed, making outright default arguably impossible. Large rich countries like the US have credible central banks, which means investors have little fear of those countries using, or allowing, massive inflation to devalue their debts, or that they will mismanage policy so severely that they end up with hyper inflation. Policy makers can lean heavily on government bond yields, reducing interest expense. Credit ratings may matter more for countries without sound currencies and trustworthy central banks.
And credit quality is just one factor that investors consider when deciding how risky a bond is. They also reckon with liquidity, which is the ease of buying and selling a security. That’s especially important when times get tough, as investors hunker down and become less willing to buy anything with a whiff of risk. On this measure, the US Treasury is still No. 1, as the deepest and most liquid market in the world.
Furthermore, there’s a case to be made that a pandemic is exactly the time when countries should be spending heavily. If the government dishes out wisely to reduce scarring in the labor market, prevent social and political unrest, and to set up the economy for a faster rebound, then it could be money well spent, eventually enhancing its credit credentials.
Still, financial markets will be in an awkward position if the US loses another AAA rating. Either credit ratings don’t matter—for some countries, at least—or the US Treasury is no longer the world’s risk-free asset. Again, if history is any indication, investors will probably go with the former explanation, that US credit rating isn’t what matters to them.