US Downgrade - What to Trade Now?

FITCH DOWNGRADES USA LONG-TERM CREDIT RATING TO AA+ FROM AAA

The rating downgrade of the United States reflects the expected fiscal deterioration over the next three years.Cites repeated debt limit standoffs and last-minute resolutions.In Fitch's view, there has been a steady deterioration in standards of governance over the last 20 years.We expect the general government deficit to rise to 6.3% of GDP in 2023, from 3.7% in 2022.Fitch forecasts a GG deficit of 6.6% of GDP in 2024 and a further widening to 6.9% of GDP in 2025.The interest-to-revenue ratio is expected to reach 10% by 2025 (compared to 2.8% for the 'AA' median and 1% for the 'AAA' median).Following the notable downgrade of the USA by S&P on August 5, 2011, a significant event has occurred. The previous downgrade had triggered a profound risk-off sentiment in the financial markets, gaining attention with its own dedicated Wikipedia page. This latest downgrade is anticipated to have a similar, if not more severe, impact, as it means that two out of three US credit rating agencies now rate the US as sub-AAA.

During the previous episode, as documented in the Wikipedia entry, global stock markets experienced a decline on August 8, 2011, shortly after the announcement. The three major US stock indexes all saw a drop of between five and seven percent in a single day. Interestingly, despite the downgrade affecting U.S. treasury bonds, their prices rose, and the dollar strengthened against the euro and the British pound. This indicated a widespread movement toward safe assets, reflecting concerns about the ongoing European debt crisis.

In an unexpected move, the credit rating of the US has been downgraded due to concerns over its fiscal deterioration, mounting debt burden, and governance issues spanning the last two decades. These challenges encompass recurring disputes over the debt limit and delayed resolutions, reflecting a decline in governance standards. Fitch highlights the absence of a medium-term fiscal framework, a convoluted budgeting process, and insufficient progress in addressing long-term issues related to the costs of an aging population.

Projections indicate that the general government (GG) deficit will increase to 6.3% of GDP in 2023, up from 3.7% in 2022, attributed to reduced federal revenues, increased spending, and higher interest costs. State and local governments are also expected to run deficits. Although the Fiscal Responsibility Act offers some improvements, significant fiscal consolidation is not anticipated before the 2024 elections.

Moreover, the forecasted GG debt-to-GDP ratio shows a continuous rise throughout the projection period, reaching 118.4% by 2025, making the US fiscal position vulnerable to potential economic shocks. Despite these challenges, the US ratings are supported by its robust, advanced, and diverse economy, along with the US dollar's status as the world's primary reserve currency, granting the government exceptional financing flexibility.

Looking ahead, Fitch predicts a mild recession in the US during the fourth quarter of 2023 and the first quarter of 2024, influenced by tighter credit conditions, weakened business investment, and reduced consumption. Additionally, slow annual real GDP growth is anticipated, and the Federal Reserve's interest rate hikes pose challenges in achieving the 2% inflation target.

Ratings Downgrade: The downgrade in the United States' rating is a result of the projected fiscal deterioration in the coming three years, coupled with a significant and escalating burden of general government debt. Additionally, the erosion of governance standards relative to 'AA' and 'AAA' rated peers over the past two decades has been evident through repeated debt limit disputes and last-minute resolutions. 

Erosion of Governance: Fitch observes a consistent decline in governance standards, particularly concerning fiscal and debt matters, spanning the past two decades, despite the bipartisan agreement in June to suspend the debt limit until January 2025. The frequent political standoffs over the debt limit and the eleventh-hour resolutions have undermined confidence in the government's ability to manage its finances effectively. Moreover, the absence of a medium-term fiscal framework, a complexity in the budgeting process compared to most peers, and the impact of several economic shocks, tax cuts, and new spending initiatives have all contributed to successive debt increases in the last ten years.

Furthermore, addressing medium-term challenges linked to the escalating costs of social security and Medicare, driven by an aging population, has seen limited progress. These factors combined paint a concerning picture of the fiscal outlook and governance practices of the government.

Here is what happened in markets the last time the US was downgraded: Stocks, FX and gold.The recent Fitch downgrade of the US is significant news, occurring nearly 12 years after Standard & Poor's downgraded the US to AA+. Like the previous downgrade, the announcement was made late on a Friday afternoon, giving the market the entire weekend to absorb the information. However, the extended time did not offer much comfort, as the S&P 500 experienced a sharp decline from 1199 to 1119, ending the day on a low note.

SPX

Source: Prime Market Terminal Significantly, that news arrived when the market was in a precarious condition following two weeks of substantial selling.

In the foreign exchange market, the response was somewhat varied, with the US dollar witnessing selling pressure countered by buying owing to the flight to safety. Additionally, the euro was facing its own challenges as the euro debt crisis was beginning to take shape.

EUR

Source: Prime Market TerminalRemarkably, US bonds experienced a rally on the day of the downgrade, driven by a strong flight-to-safety demand that overshadowed any selling pressure resulting from the downgrade.

During the previous downgrade episode, gold emerged as a major beneficiary, rallying and continuing its upward trajectory, eventually reaching a long-term high.

XAUUSD

Source: Prime Market TerminalHowever, it is essential to acknowledge that each situation is unique, and a US downgrade this time may not be as 'unthinkable.' Regardless, it is valuable to bear historical context in mind.

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