Will the Ratings Agencies Catch up to Reality?

Executive Summary

Last Friday Moody’s joined its peers in downgrading U.S. credit one level, from Aaa to Aa1. This came after Fitch lowered their rating in 2023, and S&P took theirs down one notch in 2011. Many are speculating as to why; however, the important thing is lower ratings usually means higher interest rates. Conversely, in 2011 when S&P downgraded, interest rates actually fell along with the stock market. Previously I have written about the unsustainable levels of U.S. debt, currently around $36 trillion. Annual fiscal deficits are projected at $2 trillion, not including Social Security shortfalls, which could mean more U.S. debt. In my opinion, the weakening of the economy could exert downward pressure on the long end of the Treasury curve, which could outweigh Moody’s downgrade. Will they ever catch up to reality?

For further analysis, continue to read The Details below for more information.

“Getting rid of a delusion makes us wiser than getting hold of a truth.”
–Ludwig Borne

The Details

Last Friday, Moody’s finally joined its peers in downgrading U.S. credit. Moody’s lowered U.S. credit one level, from the top tier, Aaa, to Aa1. This came after Fitch lowered their rating in 2023, and S&P took theirs down one notch in 2011. According to Moody’s (via CNBC.com),

“This one-notch downgrade on our 21-notch rating scale 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. […]

Successive U.S. administrations and Congress have failed to agree on measures to reverse the trend of large annual fiscal deficits and growing interest costs. We do not believe that material multi-year reductions in mandatory spending and deficits will result from current fiscal proposals under consideration.”

The question one might ask is, why now? The financial system nearly collapsed in the Financial Crisis of 2008-2009. And, during the pandemic years, the economy came to a halt. Fed funded deficits took off after the Financial Crisis. S&P recognized problems in 2011, yet Moody’s held off until now. Was it due to the fact that deficits continue at unsustainable levels even during “good years”? Or was it because interest rates have jumped significantly over the past few years?

Past actions, or the lack thereof, have led me to become a skeptic when speaking of the rating agencies. Do their ratings actually mean anything? Well, since certain banking and investment regulations rely on their ratings, I guess some in the community give credence to their ratings. But remember, during the Financial Crisis, debt that was effectively junk was assigned triple A ratings by all of the rating agencies. Just watch the movie The Big Short to see the ratings scandal up close.

Downgraded debt implies higher risk and thus should lead to higher interest rates on the debt. However, in the immediate aftermath of the S&P downgrade in August 2011, rates actually fell, along with the stock market. As of this writing, Monday afternoon, May 19, the yield on the 10-year Treasury Note is up about 0.03 to 4.469% and the 30-year Bond is up 0.038 to 4.935%, and the stock market has been volatile, moving in both directions.

I have written extensively of late about the debt crisis faced by the U.S. I believe the ratings agencies will continue to be a day late and a dollar short. The crisis, in my opinion, is much more severe than dropping ratings to the second highest level. At this level, banks and pensions should not be impacted with regard to their Treasury investments. Let’s briefly review the fiscal crisis. In the graph below, the Federal debt (in red, left side) is over $36 trillion. But, the concerning part, besides the massive interest costs at higher rates, is the rate of change of the debt (blue line, right side).

Notice, during the post-1983, 2009 and 2020 recessions, the debt jumped over 20%, year-over-year, each time. At today’s debt level, if a recession appears (which is very likely), that could mean a jump in debt of over $7 trillion. And this is on top of the existing $2 trillion deficits that appear to be here for the foreseeable future. And do not forget that the Social Security Trust Fund is projected to be depleted in eight years, requiring a surge in new debt issuance.

While past actions have rendered the ratings agencies almost ludicrous, their ratings still maintain influence in the regulatory environment. The recent move by Moody’s was an example of them playing “catch-up.” Some might argue that their timing was political in nature. I will not delve into that discussion.

In my opinion, the weakening of the economy will likely exert downward pressure on the long end of the Treasury curve. This could outweigh the slight downgrade by Moody’s. However, any downgrade below each agency’s top three levels will probably invoke a steeper response from the bond market. Will the ratings agencies ever catch up to reality? Doubtful.

The S&P 500 Index closed at 5,958, up 5.3% for the week. The yield on the 10-year Treasury Note rose to 4.40%. Oil prices increased to $62 per barrel, and the national average price of gasoline according to AAA rose to $3.18 per gallon.