Moody’s rating downgrade on US government debt

On May 16th Moody’s announced that it had downgraded US government debt to Aa1 from Aaa and changed the outlook to stable from negative. This is now the first time that the US does not hold a triple-A label from any of the big three credit rating agencies with S&P downgrading in 2011 and Fitch in 2023.

Moody’s rationale for the downgrade was primarily due to a significant deterioration in fiscal fundamentals accumulated over more than a decade. In the press release by Moody’s, they cite persistent and large fiscal deficits - fuelled by broad tax cuts, increased mandatory spending, and political gridlock - which have pushed the national debt higher. These factors, along with increasing borrowing costs as interest payments consume a larger share of government revenue, have raised serious concerns about the sustainability of US fiscal policy.

Despite these negatives, Moody’s maintained a stable outlook on US debt highlighting a strong and resilient US economy, and a history of effective monetary policy led by an independent Federal Reserve that provides reassurance that, despite fiscal issues, the country can manage monetary challenges effectively.

What does this mean for bond markets?

Implications of the downgrade are negligible but comes at a time of declining fiscal credibility. While the rationale for the downgrade is not new news, it has highlighted concerns over persistent fiscal challenges, and while it hasn’t triggered a dramatic market sell-off, it signals potential storm clouds ahead for Treasuries. Historically, similar downgrades, such as the 2011 S&P decision or the 2023 Fitch downgrade, did not cause major sell-offs. This was largely because investors still view Treasury securities as a critical benchmark for safety, backed by the world’s largest economy and the dominant US dollar.

Despite the recent modest rise in yields in the days following the downgrade, the reaction in the market has been relatively muted. Although fiscal pressures loom, the overall debt situation is, so far, manageable. Despite turbulent times, the fundamental demand for Treasuries - especially from traditional buyers - will prevent long-term destabilisation. Despite obvious challenges facing US public policy, there is still demand from foreign buyers, with foreign holdings of US debt up 29% to over $9 trillion, as of March 2025 from $7 trillion 2020.

Term premiums continue to increase on the back of negative sentiment

In the short term, bond market vigilantes are starting to inflict some pain to US yields. Rising debt levels, a history of political gridlock over deficit reduction, and the possibility of further contentious debt ceiling negotiations have put a spotlight on long-term fiscal unsustainability. This anxiety is partly reflected in the market through an elevated 10-year Treasury term premium, which has not yet fully normalised since the dislocations seen earlier in April.

In addition, while the short end of the curve remains relatively unchanged since last month, reflecting the Fed’s reluctance to commit to further rate cutting amidst tariff led inflation uncertainty, the long end of the curve has increased, as both foreign and domestic investors demand more of a premium for holding longer dated US debt.

Source: Bloomberg, Charles Stanley