The Breakdown - Is the US Credit Rating Downgrade a Nothingburger?

Episode Date: August 2, 2023

NLW explores a range of reactions to Fitch's decision to downgrade US sovereign debt from AAA to AA+ from the political responses to the market response to the shoulder shrug of people who don't think it's really possible to compare the US to anyone else. Today's Episode Sponsored By: In Wolf's Clothing -- The first startup accelerator exclusively for Bitcoin and Lightning startups -- Applications for Cohort 3 open NOW -- https://wolfnyc.com/apply ** Enjoying this content? SUBSCRIBE to the Podcast: https://pod.link/1438693620 Watch on YouTube: https://www.youtube.com/nathanielwhittemorecrypto Subscribeto the newsletter: https://breakdown.beehiiv.com/ Join the discussion: https://discord.gg/VrKRrfKCz8 Follow on Twitter: NLW: https://twitter.com/nlw Breakdown: https://twitter.com/BreakdownNLW

Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. What's going on, guys? It is Wednesday, August 2nd, and today we are talking about the U.S. debt being downgraded. Before we get into that, however, if you are enjoying the breakdown, please go subscribe to it, give it a rating, give it a review, or if you want to dive deeper into the conversation, come join us on the Breakers Discord. You can find a link in the show notes or go to Bit. L-Y slash breakdown pod. Hello friends, it is a macro day here on the breakdown. We're going to be talking all about this U.S. sovereign debt downgrade and what it means

and the different interpretations of it. But before we do, on a day where Michael Saylor has decided to try to buy another three quarters of a billion dollars of Bitcoin, I want to one more time urge you guys to go check out the in Wolf's clothing Bitcoin Accelerator. Wolf, as you have heard, is the first accelerator dedicated entire. entirely to Bitcoin and Lightning startups. They are just about to close applications for their third cohort this Friday. And if you are building or interested in building a company in the Bitcoin and Lightning space, or maybe you want to deal with something new like Ordinals that surrounds it,

this is the support program for you. Go to WolfnYC.com to learn more and to potentially apply. Thanks to Wolf for supporting the show. Now, to today's main topic. Yesterday, ratings agency Fitch downgraded U.S. sovereign debt. The firm cited ballooning budget deficits and the deteriorating state of governance across the nation. Now, Fitch had flagged back in May that it was considering a downgrade during the debt ceiling standoff, but didn't act on their concerns. The downgrade cut the U.S. government's rating by one level from AAA to AA plus. This move echoes a controversial downgrade by fellow ratings agency's standard and pores days after the resolution of the 2011 debt ceiling crisis. S&P has maintained that lower rating for the U.S. government to this day.

Fitch said in the statement, quote, The rating downgrade of the United States reflects the expected fiscal deterioration over the next three years, a high and growing general government debt burden, and the erosion of governance relative to AA and AAA-rated peers over the last two decades. Now, as you might expect, U.S. Treasury Secretary Janet Yellen was not happy with the downgrade. Releasing her own statement shortly afterwards, she said, I strongly disagree with Fitch's ratings decision. The change by Fitch ratings announced today is arbitrary and based on outdated data.

Yellen argued that many of the indicators which Fitch relies upon deteriorated between 2018 and 2020, but have since recovered. Crucially, those included the recent passage of major bipartisan legislation around raising the debt ceiling and authorizing infrastructure investment. Yellen added that, quote, Fitch's decision does not change what Americans, investors, and people all around the world already know, that Treasury securities remain the world's preeminent, safe and liquid asset, and that the American economy is fundamentally strong. Now, White House officials also weighed in on the downgrade. One senior official claimed, quote, this is a bizarre and baseless decision for Fitch to make now. It simply defies common sense to take this downgrade as a result

of what was really a mess caused by the last administration and reckless actions by congressional Republicans. The official also noted that key governance metrics analyzed by Fitch have improved during the Biden presidency. Biden's re-election campaign spokesperson was even more aggressive with the partisan rhetoric, stating that, quote, this Trump downgrade is a direct result of an extreme MAGA Republican agenda defined by chaos, callousness, and recklessness that Americans continue to reject. Senate Majority Leader Chuck Schumer also got on board with Democrat talking points, stating that, quote,

the downgrade by Fitch shows that House Republicans' reckless brinkmanship and flirtation with default has negative consequences for the country. Republicans need to learn from their mistakes and never push our country to the brink of default again. Now, of course, these comments from the administration don't really appear to address the long-term concerns raised by Fitch in their downgrade statement. The ratings agency wrote, quote, there has been a steady deterioration in standards of governance over the last 20 years, including on fiscal and debt matters, notwithstanding the June bipartisan agreement to suspend

the debt limit until January 2025. The repeated debt limit political standoffs and last-minute resolutions have eroded confidence in fiscal management. In other words, Fitch is arguing that this isn't about one administration or another. It's about a long-term pattern that cuts across the D's and the ours. For Fitch, the unsustainable growth in U.S. government debt and the continued lack of serious engagement with deficit reduction was also a big concern. Their statement read, the government lacks a medium-term fiscal framework unlike most peers, and has a complex budgeting process. These factors, along with several economic shocks, as well as tax cuts and new spending initiatives, have contributed to successive debt increases over the last decade.

Additionally, there has been only limited progress in tackling medium-term challenges related to rising Social Security and Medicare costs due to an aging population. Fitch noted that its modeling forecasts the deficit rising to 6.9% of GDP by 2025 from last year's level of 3.7%. Much of the added stress on the budget comes in the form of additional interest payments, which Fitch has forecast to represent 10% of revenue by 2025. This metric compares extremely poorly to other nations with solid credit ratings. The median for countries with a double A rating is only 2.8%, while the median and AAA-rated country spends only 1% of revenue on interest payments. While the overall debt-to-GDP ratio for the U.S. did contract slightly over the past two years, it is forecast to dramatically

rise from here. In 2019, the U.S. debt to GDP ratio crossed 100%, and it is set to reach 118.4% by 2025. One of the more striking things in Fitch's statement was the recognition that there is no plan to tackle medium-term fiscal challenges which threaten to cause the deficit to spiral out of control. Fitch wrote, over the next decade, higher interest rates in the rising debt stock will increase the interest service burden, while an aging population in rising health care costs will raise spending on the elderly absent fiscal policy reforms. They noted that with no change in policy, the Congressional Budget Office has forecast that interest costs will represent 3.3% of GDP by 2033, and that spending on Medicare and Social Security will escalate to 1.5% of GDP over the same time period.

According to estimates, both the Social Security Fund and the Hospital Insurance Trust Fund, which pays for Medicare, will be depleted by 2035. And unfortunately for the Democratic, Democrats' narrative, Fitch's scorecard for the health of the government's balance sheet did not appear to be just about Trump tax cuts, or, frankly, constant partisan brinkmanship around the debt ceiling. Rather, it included concerns about deep systemic and structural insustainability embedded in the way that government finances operate. Maya McGinnis, the president of the committee for a responsible federal budget, drilled home this point, stating that today's downgrade should be a wake-up call. Whether one agrees with Fitch's decision to downgrade the United States government or not, we are clearly on an unsustainable fiscal path. We need to do better. Fitch also poured some cold water on recent improvements in macroeconomic indicators. They put forward a warning that they expect a mild recession to begin towards the end of this year.

They noted that the Fed's core inflation metric, core PCE, has remained, quote, stubbornly high at 4.1% despite an aggressive hiking cycle. Throughout the statement, Fitch put forward that their baseline assumption was that interest rates would not decrease significantly to give the government more breathing room. Instead, their projection was for, quote, sustained higher interest rates compared with pre-pandemic levels. Now, what about what makes the U.S. different? Fitch did recognize that the U.S. dollar holds the status of, quote, the world's preeminent reserve currency, which gives the government extraordinary financing

flexibility. They also noted that the U.S. still maintains a, quote, large, advanced, well-diversified, and high-income economy, supported by a dynamic business environment. However, Fitch pointed out that the U.S. dollar status is not a guarantee forever. They warned that one of the key indicators they were watching when considering further credit downgrades was, quote, a decline in the coherence and credibility of policymaking that undermines the reserve currency status of the U.S. dollar, thus diminishing the government's financing flexibility. Now, one thing that is worth noting on this is that there are some who are skeptical of the entire ratings agency process when it comes to sovereign debt. The knock on it has always been

that the finances of countries operate very differently to those of corporates, and that frankly the ratings process and analysis which underpins it is not a particularly refined one when it comes to sovereign nations. Add on top of that, analyzing the finances of the issuer of the global reserve currency and the math gets even fuzzier. In other words, geopolitics, military strength, and culture all play a role in the creditworthiness of the United States, and those don't fit neatly into any spreadsheet. There's also the complete lack of viable comparison. There is no other country that has the global reserve currency. So, Fitch is unable to compare the health of the U.S. to a totally similar peer nation. To put it really crisply, it's not clear how much of a debt burden

would cause investors to lose full faith in the credit of the U.S. So pretty much the best, you know, that ratings agencies can do is point to relevant factors as they deteriorate. But what did the markets think about this? Responses were fairly mild. The yield on the two-year treasuries rose by three basis points in overnight trading, a small increase bringing the implied interest rate to 4.87%. The Dixie or Dollar index softened slightly, but quickly flipped in the dip, and this measure of the U.S. dollar against other major currencies is still more than 2.3% higher than local lows recorded in mid-July. Analysts pointed out that if we see a repeat of market action from the last debt downgrade in 2011, then the dollar in U.S. treasuries could paradoxically perform well.

David Croy, an interest rate strategist at Australia and New Zealand banking group, said, I suspect the market will be in two minds about it. At face value, it's a black mark against the U.S. reputation and standing, but if it fuels market nervousness and a risk-off move, it could easily see safe haven buying of U.S. treasuries in the U.S. dollar. Laura Fitzsimmons, executive director of macro rates and FX sales at J.P. Morgan and Sydney said, the 2011 experience saw the flight to quality for U.S.D. and U.S. Treasuries in that environment, contrary to what would normally occur on a sovereign downgrade given the U.S.'s key global position. Hoi Chen, an economist at United Overseas Bank and Singapore,

said, investors are not likely to sell off treasuries and droves due to the downgrade, because they are still amongst the most liquid and safe assets. Diversification will continue, but there's unlikely to be a knee-jerk reaction from the downgrade. Diversification happens for reasons including geopolitical tensions. This, I think, is a super important point. There is no doubt if you look at the patterns that there has been a diversification away from treasuries over the last 10 years. There are a ton of different reasons for that, and in many

cases, the reasons are localized to the specific economies that are diversifying away. I'd be fairly confident wagering that when the history books are written, the biggest factor in countries diversifying away from the U.S. dollar in the 2022-2020 period is not going to be a fitch downgrade, but the weaponization of the global swift system in the wake of Russia's invasion of Ukraine. On top of that, it wasn't like this was an out-of-the-blue type of thing. Mark Cranfield of Markets Live pointed out that this downgrade decision was really just a culmination of concerns that led to a negative outlook warning in May. He said, there shouldn't be much lasting impact on treasuries as Fitch put the U.S. onto a stable outlook from negative. That means another move is very

unlikely. It's a one-and-done operation and marking to market with S&P's AA plus rating. Amy Patrick, money manager at Pendle Group, agreed with that outlook, saying, these rate cuts are a bit like the debt ceiling debacles. They can cause a bit of short-term angst but never amounts to anything much. She pointed out that when it comes to U.S. Treasuries, there just aren't, quote, credible alternatives in terms of being both safe enough and large enough. Now, when it comes to the chattering class on Twitter, once again, things were fairly political. Former Treasury Secretary Larry Summers said, the United States faces serious long-term fiscal challenges. But the decision of a credit rating agency today, as the economy looks stronger than expected, to downgrade the

United States, is bizarre and inept. Mohamed El Eryan said, I am very puzzled by many aspects of this announcement as well as by the timing. I suspect I won't be the only one. The vast majority of economists and market analysts looking at this are likely to be equally perplexed by the reasons cited in the timing. Overall, this announcement is much more likely to be dismissed than have a lasting disruptive impact on the U.S. economy and markets. Former Obama chairman of the Council of Economic Advisors, Jason Furman wrote, this is completely absurd and is more likely to show that Fitch is irrelevant to the views of investors in U.S. sovereign debt than it is to show investors anything about the United States. Paul Krugman wrote, The U.S. has a long fiscal problem

because we have effective blocking coalitions against both spending cuts and tax increases. But what would make that problem seem worse this year than a year ago? The biggest economic news over the past year has been America's remarkable success at getting inflation down without a recession, suggesting that we won't have to go through a prolonged slump in output and hence revenue. Longer-run economic prospects have also improved at least somewhat for two reasons. Legal immigration is up, which is good for labor supply, and there are at least hints that AI will lead to at least a modest bump in productivity. Maybe the important thing to realize is that when it comes to sovereign debt,

rating agencies have no inside information and a lousy track record. Remember when S&P downgraded America in 2011? Neither do I. It would be mildly interesting to get the inside story of how Fitch arrived at this strange decision, but I'll be shocked if markets react at all. Now on the flip side, where people who have been beating the drum of U.S. fiscal and sustainability for some time. Luke Groman said, the U.S. cannot mathematically sustain their debt and deficits without sustain negative real rates. So don't tell me that the downgrade doesn't make sense. Tell me which suckers at the card table collectively have a big enough balance sheet to hold $32 trillion in debt at negative real rates.

In Arte Carlo Doss writes, Bidenomics comes with a price tag, and you know the U.S. is heading towards a government shutdown later this year. Their point on erosion of governance is certainly valid, and so is their point on sustainability of debt trajectory. US is now pissing away 14% of tax revenues and interest payments. Better sober up and get cracking with fiscal consolidation as opposed to shooting the messenger. Jim Bianco points out that functionally, it probably doesn't matter.

and not just on a psychological level. He writes, This is important because the U.S. was split-rated with Mitch and Foodies at AAA and S&P at AA Plus. This meant despite the 2011 S&P downgrade, the U.S. was still a AAA country. But now with the downgrade today, it is no longer the case. When S&P downgraded the U.S. in 2011, it was a shock and concern as many financial contracts were written that collateral had to be AAA rated. Since the U.S. was split-rated and still AAA, it dodged the bullet. In the subsequent 12 years, most of these financial contracts have been rewritten to include debt-backed by the U.S. government or words to this effect. So this will not lead to a forced unwind of

repos, loans, derivatives, and investment contracts like government mutual funds and money market funds. Even though the U.S. might now be split-rated AA-plus, it is still debt-backed by the U.S. government. This is one of those rare situations where I kind of think everyone's right to a degree, except maybe the most partisan political points. What I mean by that is that I think Jim Bianco's point that this is unlikely to have major impacts just structurally is correct. When it comes to the economists who say that markets are likely to forget about this, I also find that to be likely correct. When it comes to folks who say that it's very hard for a ratings agency to really figure out how to judge the U.S. relative to everyone else, I think markets would

also agree with that. Now, when it comes to the political talking points that this is just one party's fault or another, I obviously find that much less compelling, and even more than not finding it compelling, I don't find it particularly useful, especially when Fitch is explicit about the fact that this is a 20-year trajectory question. And finally, when it comes to the people who have been beating this drum, who are concerned about the long term, I agree that this should be a context to revisit what they've been saying, and ask whether there are other choices we can make in order to avoid some of the consequences that this downgrade reflects. So in some ways, this is a big deal, at least in terms of what it might imply for the future, while in other ways

not being much of a deal at all. Go figure, man. Anyways, that's going to do it for today's breakdown. big thanks one more time to Inwolf's clothing for sponsoring the show, Wolf NYC.com for that application, and of course a big thanks to you guys for listening. Until next time, be safe and take care of each other. Peace.