Deal Or No Deal, US Downgrade Still Likely

Would (another) US downgrade matter with the country poised to avert a worst-case debt ceiling outcome?

As is the case with so many other pressing questions facing market participants in 2023, the answer is “yes and no.” “Yes,” in the sense that a downgrade would speak (loudly) to an ongoing, multi-faceted social crisis. But “no,” in the sense that if the US doesn’t actually default, no one would shun Treasurys in a downgrade scenario — instead, investors would likely buy them.

After putting the US on notice last week, Fitch may still go ahead with a ratings cut, deal or no deal inside the Beltway. If they did pull the proverbial trigger, the ratings action rationale would center not just on America’s fiscal trajectory, but also on the read-through of what the agency last week described as “signs of deterioration in governance.” That deterioration was the subject of May’s monthly letter+. Suffice to say anyone feeling nervous about the future of American democracy won’t be blamed for their trepidation, including Fitch if that’s what they’re concerned about.

So, what would happen in the event of a downgrade? Would it be a rerun of 2011’s paradoxical “buy the debt of the defaulter” dynamic? Probably, if you ask TD’s Gennadiy Goldberg and Molly McGown, who suggested the bid for Treasurys would manifest as a bull steepener given the implications for monetary policy.

“The front-end would likely lead the rally in rates as we would expect the market to lower the pricing for Fed rate hikes,” Goldberg wrote, adding that although the bank wouldn’t “expect the reaction to be quite as aggressive as after the 2011 downgrade,” the recent selloff in rates reflects the market “pricing in a significant amount of optimism,” which in turn suggests scope for lower yields on an adverse headline.

In addition, TD said GSE debt may widen, albeit only “modestly.” “Both Fannie Mae and Freddie Mac were downgraded in tandem with the US in 2011, and we would expect another downgrade in GSE ratings if the US is downgraded,” the bank said, adding that forced selling is nevertheless unlikely. Spread product, Goldberg noted, “broadly widened during 2011,” but the comparison isn’t straightforward — Europe’s debt crisis was bubbling up at the time.

I assume this is obvious to most readers, but the point here isn’t about a reinvigorated bull steepener, or agencies or spread-product widening. Rather, the point is that at least some analysts still expect the US to be downgraded, and as discussed at length in the monthly letter, the rationale is (at least) as much about political and societal disintegration as it is about the nation’s fiscal trajectory. That’s disconcerting, to put it mildly.

If you ask Goldberg and McGown, it’s eminently possible that Fitch will move forward. The agency cited the “decline in coherence of policymaking [which] suggests that even if the debt ceiling is raised,” Fitch might’ve already made up its mind. “We view [the] communication as an indication that such action may be likely, and expect Fitch to follow through with a downgrade,” TD said.