Moody’s, S&P and Fitch are still the big three credit rating agencies that rate a borrower’s ability to pay back debt. These agencies rate everything from US Treasurys to riskier high yield corporate debt. A AAA rating generally suggests a bond has a very low probability of default. CCC rated debt on the other hand has about a 20% probability of defaulting in the next year. We’ve recently seen credit rating downgrades outpacing upgrades with a few downgrades garnering headlines.
Fitch Downgrades the United States
The first such downgrade occurred this summer with Fitch downgrading the United States debt from AAA to AA+. In terms of default probabilities, this changes very little. The United States will likely always fulfill its debt. Our debt is denominated in US dollars and the United States can always print more dollars to meet its obligations. Fitch, however, did highlight some longstanding issues that may make US debt worth less in the future in real, inflation-adjusted terms.
First, Fitch highlighted the deterioration of the fiscal picture over the next three years. The US continues to run very high deficits. The Federal deficit, taxes less spending, hit $1.39 Trillion in the first nine months of this fiscal year, up 170% from the same period the prior year. Deficits at these levels are rare outside of wars and recessions. However, outside of a brief period at the turn of the century, the US has systematically spent more than it’s made. Our federal debt held by the public has grown from roughly 25% of our GDP fifty years ago to over 100% today.
These sustained debts, rising deficits and higher interest rates as of late have led to a surge in spending on interest payments. The interest cost of servicing our debt jumped 25% in the first nine months of this fiscal year and is approaching $1 Trillion on an annual basis. The non-partisan Congressional Budget Office (CBO) estimates that spending on interest payments alone will exceed both our defense and nondefense discretionary spending by the end of this decade. By 2050, the CBO sees interest payments exceeding Medicare and Social Security spending assuming those trust fund balances last that long.
Next, Fitch highlighted the erosion of trust in the US government following yet another debt ceiling debacle. They also noted the events on January 6th, 2021. President Trump has now been indicted four times this year alone. President Biden’s son, Hunter, faces his own legal issues. With Congressional Republicans and Democrats still far apart on future spending plans, we are facing another possible government shutdown in October just as the 2024 presidential election campaigning heats up. While the US remains one of the cleanest dirty sheets on the global debt stage with the deepest liquid market in the world, Fitch’s concerns appear valid.
Not surprisingly, Treasury Secretary Janet Yellen took issue with Fitch’s negative assessment and noted it was based on outdated numbers and events. S&P in fact downgraded the US to AA+ back in 2011 for similar reasons. Nonetheless, the Fitch downgrade came at an unfortunate time and bonds have sold off. Yellen had just boosted her forecast for borrowing in Q3 from $733 Billion to $1 Trillion. Also, just as the US is stepping up its borrowing needs and Treasury issuance, demand from its largest customers is waning. The Federal Reserve continues to shrink its balance sheet. Japanese investors, the US’s largest foreign creditor, now find their own domestic yields relatively more attractive. China, the second largest foreign creditor, is also paring their Treasury holdings given slowing exports and continued decoupling. This all has led to a difficult August for Treasurys with longer bonds giving back their year-to-date gains and back in negative territory after the steep bond declines suffered last year.
So, what are we doing? We do not think the US will ever default on its debt but do remain underweight Treasury bonds. Despite both the quality and quantity issues noted above, bond investors remain willing to lend money to the government for 10 and 30 years at 4.2% and 4.3% respectively. These yields are both below today’s 4.7% core inflation rate and 6-month Treasury bills at 5.5%. Bond investors appear willing to accept these relatively low yields due to their recession concerns, but we would prefer to see yields above inflation before making new long-term loans to our troubled government.
Corporate and Banking Downgrades
Recession jitters and downgrades can also be seen on the corporate side. Ratings downgrades across the corporate sector have recently outpaced upgrades for the first time since the pandemic. While this also occurred in 2016 without a recession, occurrences in 1990, 2000, and 2007 did precede recessions. Adding to investor angst and recessionary reflexes, S&P just downgraded five US regional banks following Moody’s similar downgrades two weeks ago.
Both firms cited pressures making life tough on banks. High yields on risk-free Treasury bills continue to make lower yielding bank deposits less attractive. This increases the cost of capital to banks at a time when their ability to borrow in the capital markets is also stressed. Banks also continue to face stress on the asset side of their balance sheet. As noted above, after a brief relief rally this year, Treasurys, a large asset for many banks, are back in negative territory year to date with potentially more pain ahead. Similarly, commercial real estate, often the largest or next largest holding for banks, remains in the spotlight. With all these stresses coupled with consumer delinquencies and corporate bankruptcies running at the fastest pace since 2010, bank loan officers have significantly tightened lending standards to levels not seen since the pandemic and outside of recessions. This all has implications for bank profitability and the economy and again begs the question as to what we are doing and recommending in this environment.
First, we continue to monitor banks, particularly counterparty banks, closely. We do not see a banking crisis ahead but certainly believe we could see more bank failures. No bank is ever entirely safe from a fear-driven bank run. Banks have quietly stepped up their borrowing from the Federal Reserve’s Bank Term Funding Program suggesting these stresses are real. We continue to keep all our excess cash in money market accounts and Treasury bills both yielding over 5%. While the FDIC to date has made all uninsured depositors whole on the recent bank failures, this is not the law. We continue to recommend that clients keep any outside operating cash below the $250k FDIC limit. If this is not possible, we would stick with the large Global Systematically Important Banks (GSIBs) which to date have avoided downgrades and acute stress.
Finally, we continue to monitor recession risks closely and remain close to our long-term targets but defensively positioned with excess cash. Outside of the recession indicators above, we see many more signals flashing red and yellow still. Whereas most investors thought a recession was inevitable last year, we have seen increased optimism for a “soft-landing” and recent stock market ebullience which all else equal makes us more cautious. In sum, we remain close to our long-term targets, cognizant that timing recessions and bear markets is impossible, but still cautious with excess cash given strong relative yields. We are beginning to see more opportunities to put this cash to work in higher yielding, inflation-topping assets, but expect to be patient given some of the stresses noted above.
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