America loses its last AAA rating

Moody's Investors Service cut the federal government's long-term issuer rating from Aaa to Aa1 on 16 May, taking away America's last top-grade sovereign credit rating. Moody's pointed to persistent, unchecked budget deficits, rising interest costs and Congress's long-running failure to agree lasting reforms to entitlements or the budget.

The announcement came after the close of trading on a Friday, giving markets a weekend to digest it. The Treasury secretary, Scott Bessent, brushed it off as a lagging indicator and blamed the spending of the previous administration. Neither response addresses the agency's central point, which is that the gap between what Washington spends and what it collects is widening under governments of both parties and is set to widen further.

Why Moody's moved now

The cut was well signalled. Moody's put its outlook on America to negative in November 2023, and it had held the country at its top grade for more than a century. What tipped the decision was the direction of policy rather than any single number. The downgrade landed as House Republicans were pushing a bill to extend the 2017 tax cuts without matching savings, and Moody's changed its outlook back to stable only once the rating itself had been cut.

The agency's projections do the rest of the work. It expects deficits to keep widening over the next decade as spending on pensions and health care for an ageing population grows and as interest absorbs a steadily larger share of federal revenue. A rating is a judgement about the path of the numbers as much as their level, and on that path Moody's saw no sign of correction.

All three agencies agree

The downgrade brings Moody's into line with the other big rating agencies, S&P, which cut its rating in 2011, and Fitch, which did so in 2023. On Wall Street the symbolism counts. For decades America was the world's benchmark for a creditworthy government. Losing the last AAA rating reflects a national debt of $36 trillion and annual deficits of more than six per cent of GDP.

Those deficits are being run at full employment and without a war or a recession to explain them, which is what separates America from most other large borrowers. Germany and a handful of smaller economies keep the top grade from all three agencies because their debts are lower or falling. America's is rising, and the interest bill rises with it as cheap debt issued during the pandemic is refinanced at today's higher rates.

There is an odd consequence. Microsoft and Johnson & Johnson, the two American companies that still hold top ratings, are now rated above the government that taxes them. Many states also keep their AAA ratings, because they are obliged to balance their operating budgets. The sovereign has become a weaker credit, on this measure, than some of the borrowers under its jurisdiction.

What 2011 and 2023 showed

The two earlier downgrades offer a guide to what comes next. When S&P acted in August 2011, after a bruising fight over the debt ceiling, Treasuries rallied, because frightened investors sold shares and bought the very debt that had just been downgraded. When Fitch moved in August 2023, yields rose over the following months, with the ten-year yield approaching 5 per cent in October, though heavy issuance and the Federal Reserve's policy did more to drive that move than the rating itself.

Nobody has to sell

Treasury yields barely moved on the news. Treasuries remain the collateral on which much of global finance runs, and they sit at the heart of banks' liquidity buffers and of foreign exchange reserves. After the 2011 downgrade American bank regulators said at once that the capital treatment of Treasuries would not change, and the same logic holds now. Very few investment mandates are written so tightly that a move from Aaa to Aa1 forces a sale.

The strongest case for ignoring the downgrade is that ratings follow markets rather than lead them, and bond investors have known the fiscal figures for years. That is fair as far as it goes. The market did show a crack in April, however, when Treasuries and the dollar fell together after the tariff announcements, a combination normally seen in emerging markets rather than in the world's reserve currency. The downgrade gives that nervousness an official label.

How the premium builds

The mechanism is slow. A fund manager comparing a ten-year Treasury with a German Bund or a Japanese government bond now sees one fewer reason to treat American debt as the default choice. Each marginal buyer who asks for a little more yield, or buys a little less at each auction, pushes up the price Washington pays. With a large share of the debt maturing within a few years, those small increments pass into the budget quickly.

The cost does not stay in Washington. Mortgage rates, corporate bond yields and the rates charged to states and cities are all priced off Treasuries, so a higher term premium is effectively a tax on every long-term borrower in the country. Home buyers and companies planning long-lived investments feel it first. Savers who buy long bonds are the obvious gainers, since they are paid more to hold the same asset.

Where the cost shows up

Any penalty will show up in the term premium, the extra yield investors demand for tying up money in long bonds, rather than in a sudden sell-off. The signs to watch are demand at auctions of ten- and 30-year debt, foreign holdings in the Treasury's monthly data, the fate of the tax bill in the Senate and the debt ceiling, reinstated in January, which must be raised within months. The downgrade will not force big investors to dump Treasuries. It does end the idea that American government debt carries no risk, and Washington will probably pay a small, lasting premium on long-term borrowing as a result. If the tax bill passes without offsets, that premium is likely to be visible in weaker long-bond auctions before the year is out.