The US government just lost its final AAA credit rating

Moody’s, the last credit ratings agency to bestow the US government with a pristine credit rating, is taking away that title.

The decision “reflects the increase over more than a decade in government debt and interest payment ratios to levels that are significantly higher than similarly rated sovereigns,” Moody’s said in a statement announcing the drop to Aa1 from AAA. “We do not believe that material multi-year reductions in mandatory spending and deficits will result from current fiscal proposals under consideration.”

Ten-year Treasury yields jumped as much as 6 basis points, reaching levels not seen since 10:00 a.m. Thursday, in the minutes following the announcement.

With all due respect to Fitch, which downgraded the US in August 2023, the more momentous downgrade that will stick in people’s minds is the August 2011 cut by S&P in the midst of debt ceiling drama that sparked fears of a potential default.

But bond yields largely fell in the wake of that announcement, because, frankly, the macroeconomic backdrop is always going to be a much larger driver of Treasuries than dictates of ratings agencies. Investors were very worried about a double-dip recession about two years removed from the end of the economic contraction tied to the global financial crisis of 2008, and sought safety in US bonds because that’s what you want to own when you’re worried about the economy.

Time has passed; circumstances have evolved. In 2022, we had a bear market in stocks where bonds offered no protection because high inflation and aggressive Fed rate hikes to try to tamp down price pressures were driving investor angst.

Right now, tariffs (which push prices higher and activity lower) remain a risk to the outlook, and are not obviously bond-positive.

Couple that with a market that has recently flirted with the idea that US exceptionalism is past its peak and you have a recipe for this downgrade to potentially leave a more enduring mark. Or not.

(The good news is that the “sell America” theme has largely manifested as “hedge America” — that is, investors are maintaining holdings of US stocks and bonds, but hedging away the US dollar exposure.)

“While survey respondents are near historic USD shorts, they have not meaningfully rotated out of US duration,” Bank of America analysts wrote in a May 9 note. “This suggests that ‘de-dollarization’ may be playing out more through hedge ratios than asset reallocation.”

While my personal view is that ratings agencies exist to a) allow people to avoid doing their own due diligence, and b) be made fun of given their history (TL;DR: watch “The Big Short”), it is also true in many cases that investment funds have limitations on what they can hold based on their credit ratings.

However, there are also often special allowances made with regard to holding US Treasuries or merely distinctions made solely between investment grade and non-investment grade debt, which makes the above more pertinent to corporate and emerging market investment holdings.