Moody's warns on America's debt

Moody's Investors Service cut its outlook on America's Aaa credit rating from 'stable' to 'negative' on 10 November. Fitch and S&P have already downgraded the United States, which left Moody's as the last agency still holding the line. The change is a sober reminder to Washington that its top-tier rating is living on borrowed time.

How the agencies fell away

Standard & Poor's was first, cutting America to AA+ in August 2011 after a debt-ceiling standoff that brought the government close to missing payments. Fitch followed in August this year, citing an erosion of governance over the previous two decades and the repeated brinkmanship over the debt limit. Moody's has kept America at Aaa since it first rated the country in 1917. A negative outlook signals that the agency sees a meaningful chance of a downgrade, typically over the following twelve to eighteen months.

Deficits, interest and gridlock

Moody's pointed to wider fiscal deficits, rising interest costs and a complete lack of political agreement on budget reform. Net interest costs are on course to exceed defence spending and are taking a growing share of federal revenue. The dollar's reserve status gives America more room than other borrowers. Persistent deficits of several trillion dollars a year will still push up the term premium on its debt.

The figures bear out the concern. The federal deficit for the fiscal year that ended in September was about $1.7 trillion, at a time of low unemployment when deficits normally shrink. Much of the debt issued at near-zero rates in 2020 and 2021 is short-dated and is being refinanced at yields above 5 per cent on bills and above 4 per cent on longer maturities. The interest bill therefore rises even if the debt stops growing, and the debt is not about to stop growing.

Gridlock on display

The politics since the announcement have done little to reassure. Congress avoided a shutdown only by passing another stopgap, signed on 16 November, that funds the government in two tranches into early next year, the second temporary measure in two months. The House spent three weeks without a Speaker in October after Kevin McCarthy was removed, before electing Mike Johnson. The Treasury said it disagreed with Moody's assessment, but neither party has proposed a credible plan to raise revenue or slow the growth of spending on pensions, health care and interest.

How ratings reach yields

The mechanism is slow. Most investment mandates and bank capital rules treat Treasuries as a special case, so a downgrade triggers few forced sales. The effect instead works through the term premium, the extra return investors demand to hold long-dated bonds. Each downgrade and warning adds a little to the perceived risk of lending to Washington for thirty years, and when the Treasury needs to sell ever larger quantities of debt, buyers can demand that extra return. The rating is less a trigger than a record of that drift.

Britain offers a guide. Moody's stripped the United Kingdom of its top rating in February 2013, and gilt yields barely moved, because the Bank of England was buying bonds and inflation was low. The circumstances today are different: the Fed is shrinking its holdings rather than buying, inflation is above target, and the supply of Treasuries is rising. A downgrade that arrives in those conditions is more likely to show up in the price of debt.

Who pays for the drift

Taxpayers bear the cost through higher interest spending, which crowds out other budget priorities. Homebuyers and companies pay too, since mortgage rates and corporate yields are priced off Treasuries. Foreign central banks holding Treasuries as reserves face a slow erosion of the case for keeping so much in one asset, though they have few alternatives of comparable size and liquidity. The main beneficiaries are holders of short-dated bills, who earn high yields with little exposure to long-term fiscal risk.

A downgrade would also ripple beyond Treasuries. Agencies seldom rate a domestic borrower above its own government, so institutions whose standing rests on federal backing, such as the mortgage giants Fannie Mae and Freddie Mac, tend to move with the sovereign. When Fitch downgraded America in August, it cut both of them as well. Their funding costs barely changed, which fits the view that ratings record the market's judgement more than they drive it.

The case against alarm

The counterargument is that ratings matter little for a country that borrows in its own currency and issues the world's reserve asset. America cannot be forced to default for lack of dollars, and the debt ceiling, the only real route to a technical default, is suspended until early 2025. When S&P downgraded America in 2011, Treasury yields fell as investors sought safety. That record suggests the market will look through a Moody's downgrade as well.

That may be true for the immediate market reaction. The deeper problem is that ratings agencies are following the market rather than leading it: the term premium on long Treasuries has already risen this year, and the agencies are describing a fiscal path that bond investors have begun to price. The indicators to watch are the funding deadlines in January and February, the Congressional Budget Office's next long-term outlook, and the size of the Treasury's long-dated auctions.

The negative outlook is Moody's formal notice that America will probably lose its last triple-A rating unless Congress fixes its finances. On current form, the downgrade looks a matter of when, and a year to eighteen months is the likeliest window.