Table of Contents
US Credit Rating Downgrade: Market Reactions and Insights
In recent trading sessions, major US stock indices exhibited notable resilience, particularly in light of Moody’s decision to downgrade the US credit rating over the weekend. The S&P 500 managed a slight uptick of 0.09%, rebounding from an initial decline of 1.05%, which marks its sixth consecutive day of growth. Since reaching a low on 7 April, the index has surged by 23%, and currently reflects a 1.6% increase year-to-date.
Risk-sensitive assets, including bonds, the Volatility Index (VIX), and gold, experienced temporary spikes following the downgrade but quickly returned to lower levels.
Conversely, the S&P/ASX 200 also recorded positive movement, climbing 0.8% on Tuesday after a previous decline of 0.5%.
Overview of Moody’s Downgrade
To briefly summarise, Moody’s downgraded the US credit rating from AAA to Aa1, citing multiple factors: rising debt levels, escalating fiscal deficits, and increased interest payments. The agency expressed concern over a decade-long trend of growing government debt and interest payment ratios, which substantially exceed those of similarly rated countries.
Moody’s projected that deficits could expand from 6.4% to almost 9% of GDP by 2035, attributing the ongoing fiscal issues to a lack of consensus among successive US administrations and Congress on necessary reforms.
This downgrade from Moody’s marks a significant development as it is the last of the three major credit rating agencies (after Standard & Poor’s and Fitch) to enact such a change.
Historical Context of Downgrades
Looking back, the first downgrade of the US credit rating occurred on 5 August 2011, when S&P lowered it from AAA to AA+. This historic move was prompted by a contentious debt ceiling crisis, during which the agency highlighted increasing "political risks" and a decline in the effectiveness and predictability of American governance.
At that time, market reactions were swift; the S&P 500 plummeted by 6.7%, with the VIX soaring to 45 amid heightened panic that persisted for a week.
Most recently, Fitch downgraded the US from AAA to AA+ on 1 August 2023, citing similar concerns surrounding fiscal deterioration and political instability linked to repeated debt-limit standoffs. Following this announcement, the S&P 500 dipped 1.4% while the yield on the US 10-year Treasury rose to 4.1%, its highest mark since November 2022.
Market Outcomes Post-Downgrades
Historical data shows that while previous downgrades led to short-term declines in the markets (typically lasting between one to three months), the S&P 500 ultimately stabilised and achieved impressive medium-term returns. According to Carson Investment Research, the index averaged a 19.8% rise in the year following both the S&P and Fitch downgrades.
Conclusion
Despite the technical downgrade by Moody’s, which aligns the US’s credit rating with that of S&P and Fitch at AA+, its impact on financial markets may be muted in the long run. Morgan Stanley’s Michael Wilson views the downgrade as a potential buying opportunity, particularly given the recent easing of trade tensions between the US and China, which he believes could mitigate recession risks.
However, Wilson warns that if the yield on the US 10-year Treasury surpasses 4.5%, equities could face downward pressure. On the positive side, he noted a resilient corporate earnings season and an uptick in profit forecasts, suggesting that there could still be room for equity growth despite some anticipated short-term challenges.
In summary, while the Moody’s downgrade may induce short-term market volatility, its lasting effects are likely to be minimal as the markets gradually adjust and refocus on underlying economic fundamentals.
