Last Friday, Moody’s rating agency downgraded US Treasury debt from Aaa to Aa1. This is the third consecutive downgrade by the three recognized rating agencies since 2011. The US has experienced debt rating downgrades by two other debt rating agencies: Standard and Poor’s in 2011 and Fitch in 2023. Those earlier downgrades each raised levels of concern and angst from Wall Street to Main Street initially, but ultimately did not cause the material damage. A similar downgrade might have had a far greater impact for a country of less depth and breadth in accountability as well as a lack of high levels of transparency in governance. If anything, the latest downgrade of US debt must serve as an important reminder of what most US and multinational investors have known for decades: the US (as well as many other countries) needs to address what it spends versus what it collects in taxes. The first time, however, US Treasuries paradoxically rallied as investors still saw them as the world’s safest asset. The second time, the 10-year Treasury yield climbed to around 4.49% in the immediate aftermath of the downgrade. This increase in yield reflected investor concerns that the downgrade signaled greater fiscal risks, potentially requiring higher returns to compensate for perceived increased risk in holding US government debt. As it stands, the US is still the cleanest shirt in a dirty hamper of world debt, but I still find it important to give a bit of attention to these three downgrades as they started 14 years ago, in 2011, then in 2023 and third rating agency finally threw their hat in the ring last Friday.
Here is a brief history of the downgrades just for comparative purposes, and then a more granular bullet point list of possibly “why” it was done this time:
History of downgrades
First downgrade:
Standard & Poors Downgrade Date: August 5, 2011, from 'AAA' to 'AA+'. This one got much attention due to the fact that it was the first and Standard & Poors is arguably the most highly respected.
Market Reaction:
- The downgrade triggered significant volatility and a sharp selloff in global stock markets.
- On the first day of trading after the downgrade (August 8, 2011), the S&P 500 plunged nearly 6.7%, its worst single day drop since the 2008 financial crisis.
- The Dow Jones Industrial Average fell over 630 points, and similar declines occurred in European and Asian markets.
- The selloff was driven by fears that the downgrade would raise borrowing costs, undermine confidence in US fiscal management, and threaten the US dollar’s safe-haven status.
- Since it came on the heels of the final digestion of the helicopter money from the Fed to ease the burden of the Great Financial Crisis, many thought it could be very bad.
Second downgrade:
Fitch downgraded the US long-term credit rating from AAA to AA+ on August 1, 2023. The downgrade was attributed to several factors, including:
- Expected fiscal deterioration over the next three years. Again, after the helicopter money from the Fed much like in 2009, yet over 3 times as large, much angst was present.
- A high and growing government debt burden.
- Erosion of governance, as reflected in repeated debt limit standoffs and last-minute resolutions in Congress. Congress deadlocked on how to justify such a monstrous amount.
Fitch specifically cited concerns about the US government’s ability to manage its rising debt, ongoing political gridlock over the debt ceiling, and the lack of a credible plan to stabilize the debt burden. At the time, the US debt-to-GDP ratio was projected to rise to 118.4% by 2025, far above the median for AAA-rated countries. What was not focused on was that the US dollar actually strengthened in the aftermath of the helicopter drop. This signified that the situation throughout the rest of the world was much worse.
Third downgrade:
The downgrade of US bonds on May 16, 2025, by Moody’s was driven by several interrelated fiscal and political factors:
- Rising Government Debt: Moody’s cited the United States’ escalating national debt, which had reached $36 trillion, as a central concern. The agency highlighted that US federal debt and interest payment ratios had risen over more than a decade to levels significantly higher than those of similarly rated sovereign nations.
- Persistent Large Fiscal Deficits: The downgrade reflected the ongoing failure of successive US administrations and Congress to reverse the trend of large annual fiscal deficits. Moody’s projected that federal deficits could expand to nearly 9% of the US economy by 2030, up from 6.4% in 2024.
- Rising Interest Costs: Higher interest rates have increased the cost of servicing government debt. Moody’s noted that annual interest payments were expected to surpass $1 trillion within a few years, potentially exceeding spending on defense and Medicare if current trends continued.
- Political Gridlock and Policy Uncertainty: The agency pointed to the inability of Congress and the administration to reach consensus on credible, long-term strategies to reduce deficits and stabilize the debt burden. Ongoing debates over tax cuts and spending plans, along with political polarization, were seen as obstacles to fiscal reform.
- Tax Cuts and Revenue Concerns: Efforts to extend or expand tax cuts, such as those from 2017, were expected to add trillions to the deficit over the next decade. Attempts to raise revenue through tariffs also raised fears of a trade war and economic slowdown.
- Outlook and Fiscal Trajectory: Moody’s indicated that the fiscal strategies under discussion were unlikely to yield a consistent, long-term reduction in deficits, projecting that the federal debt burden could climb to around 134% of GDP by 2035, up from 98% in 2024.
It should come as no surprise to most consumers and businesspeople that spending more than you earn is neither a prudent nor a sustainable activity to practice. When it comes to the US government it would appear to many that the level of services, benefits, and generosity the US renders to its varied constituencies among its citizenry, allies, and trading partners does not come cheap. In fact, the cost of government is considered to be so expensive and risky an endeavor that it is considered no longer prudently plausible to maintain such levels of spending without incurring some kind of financial crisis.
Yet, if one is to look at the situation in China, who has been attempting to manage deflation, collapsing factory activity, and faltering consumer demand, the comparison creates a far more different picture for the US. Just this week they have shown the pickle they are in by lowering interest rates and interest rates earned in Government sponsored bank accounts to try and stimulate economic activity. Prices in China have dropped for 31 months in a row. The nation's troubling trajectory resembles that of Japan in the 1990s which suggests China is looking for a tariff deal sooner than later.
My point is yes, it is true that things are not particularly clean and easy here in debt land, but when the US Dollar exchange rate and the measure of economic activity and growth of other measurable countries is considered, the US is still functioning quite profitably. Markets are always forward looking, and after the initial decline on Monday morning US equity indexes recovered and closed higher on the day. At the same time, the 10-year Treasury yield opened at its highest rate of the day and the rate moved lower into the close.
The V Shaped Recovery in the S&P 500 Index
The recent pausing of the April 2 tariff regime for a ninety-day period along with significant progress in trade talks with several nations further exemplified the frictional, yet effective negotiating style of President Trump. US economic data that showed resilience in the US economy and the S&P 500’s Q1 earnings season, which has repeatedly beaten earnings expectations, have in our view all contributed to a powerful rally by stocks over the last six weeks. As of last Friday, 92% of companies had announced their Q1 earnings and they were up an average of 11.9% with revenues up over 4%. Bloomberg had expected earnings to rise only 6.8%. It’s a small wonder that the markets liked this actual upside surprise and further validates the consistency of equity prices moving before the news that supports the move. The recent rally, much celebrated by bulls while questioned by bears and skeptics, has erased most of the decline sustained by the broad market from the February 19 record high to the April 8 low. Take another look at the picture above to clearly see this.
Now throw on top of this the two-hour call Trump, Putin, Zelinski, and NATO had on Monday that appears to be setting the groundwork for a truce after three years and a hopeful end to a lot of wasted money funding the conflict and we are seeing international issues that are easing concerns for the global economy.
Another point that I find interesting that the press fails to discuss is what is going on with Iran. President Trump is brokering a deal that would allow Iran to put its oil back on the world markets if they agree to not use nuclear weapons. The financial benefit to them would be so large that it could change the current state of their country, but more important than that would be the excess supply effect on world oil prices. If world oil prices drop, this could have an incredibly negative effect on Russia as they are highly dependent on their oil export income. See the action out of oil prices below. It is clear that the market once again has sniffed out something going on that would cause oil prices to drop. Do you think it is any coincidence that Trump is brokering a deal with Iran at the same time he is trying to facilitate a truce between Zelinski and Putin. Wouldn't this be great!
Next could be the tariff agreements from most of our other trading partners that could systematically fall in line as a follow up to the China talks. The coup de grâce would be to end the Israeli Palestinian conflict. And this all seems to be happening in the first 6 months of his presidency. Forget about DOGE, immigration, and tax cuts! This could collectively provide rocket fuel to the US equity markets. With the US still the largest economy in the world and the home of the world’s reserve currency, a downside reaction in the markets to the US debt rating downgrade announced last week came into question before it gained much traction. This is what Thomas Lee of FundStrat wrote yesterday:
The generally declining trend in interest rates that followed the Great Financial Crisis and COVID (and that continued a pattern since the early 1980s) allowed debt to balloon at relatively manageable levels given the historically-low cost of that debt. As rates increase, however, as they are now likely to do, it becomes more difficult to issue and maintain the same levels of mind-numbing debt, raising the costs of lending and theoretically pushing the demanded risk rate up even higher, setting off a potential debt spiral. I say "theoretical" because while that's the way it should work, it once again comes down to the market and how much benefit of the doubt it's willing to give to the U.S. exceptionalism and its fully backed guarantee to pay its obligations. To be sure, sovereign debt is different from personal or even corporate debt. The United States simply has more options to service its debt, including the ability to raise taxes as high as it deems necessary.
While the stock market has impressively shrugged off the trade-related fears that prompted the selloff earlier this year, one thing that could take us back to a "risk off" environment would be a sharp move in the bond market. The 10- and 30-year U.S. Treasury yields are already nearing their early April spike highs. The stock market has been fine with that so far, though that can always change if rates begin to accelerate further. The S&P 500 has now recovered all but 3% of the February-April decline, and, to repeat what I said last Wednesday, I don't see any prior 20% declines in the last several decades that recovered that much and then went on to make a lower low anytime soon. It's possible, but I feel it is now less probable. That makes me more inclined to proceed more normally now on an investment basis.
Now the fun begins for the Tower 68 team. The issue that we are faced with is selectivity. The small-cap index is still in a dreadful place, and this has meant that the strength of the economy is in question since smaller companies, which are more sensitive, are not keeping up with their larger brethren. This may be true, but I think a far more important measure is that of the spread between the cost of high yield debt and that of US Treasury debt. When the spread widens, fear abounds. When the spread gets smaller the market waters are calmer. See below:
Notice that these spikes are consistent with Black Swan events, yet this most recent Trump Tariff Swan has already gone out with a whimper. The highest spike was the COVID shutdown, followed by the interest rate spike that was done by the Fed when they raised interest rates quicker than has ever been done in history. This was necessary after the massive $7 trillion dump by the Biden administration.
The last point that I want to bring up is the rhyme that seems be almost perfectly accurate between first year presidents going back to 1928 and this year. I have included versions of this chart before, but want to really bring up how markets tend to rhyme more often than not. Going all the way back to 1928, the first quarter of a new presidential term has a fairly specific footprint to it. Even though Trump is clearly very different than most presidents that I can recall, the action of the US stock market is amazingly similar. Notice that this year, February 19th was the high. The average high going all the way back in history is on average, February 7th. The subsequent low that we saw this year (so far) was April 8th. Going back to 1928 the average was April 3rd, this is within 4 trading days. I am sorry, but I have a hard time finding this to be coincidental.
What I find most interesting is the action from April to August. I could only hope and pray that we continue to listen to the same rhyme!
- Ken South, Tower 68 Financial Advisors, Newport Beach
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