Why the U.S. credit rating was cut by Fitch and what it means

Americans generally expect to be No. 1 at everything. So the downgrade of the country’s credit rating for only the second time ever rattled the country’s pride and the global financial system.

The U.S. was stripped of its top-tier sovereign credit rating by Fitch Ratings on Aug. 1, echoing a move more than a decade ago by S&P Global Ratings.

Both markdowns were spurred by bitter standoffs over the nation’s borrowing.

History suggests that the impact on financial markets may be short-lived, though the move could provide fodder for more political battles.

Why did Fitch downgrade the U.S.?

Fitch said the one-step downgrade to a rating of AA+ reflects an “erosion of governance” that has “manifested in repeated debt limit standoffs and last-minute resolutions.”

That’s because every few years, through a policy of its own making, the U.S. faces the prospect of a debt default.

A law dating to 1917 led to a fixed aggregate dollar limit on borrowing – the debt ceiling – which can be raised only by agreement of Congress and the president.

That specter hung over the U.S. for the first half of 2023 as the U.S. grew perilously close to a debt limit of nearly $31.4 trillion and politicians ran down the clock.

The standoff was resolved in late May, but it fueled uncertainty again about the commitment of U.S. political leaders to put risky rhetoric aside and meet bond repayments on a mounting debt burden.

What does AA+ mean?

The AA+ rating is one level below AAA, meaning the U.S. no longer has what Fitch defines as the “highest credit quality.”

While Fitch says that AA ratings denote “expectations of very low default risk,” that’s a step down from “the lowest expectation of default risk” for AAA borrowers.

Similarly, the top rating is assigned only in cases of “exceptional strong capacity” to meet financial commitments, while AA tier credit scores indicate a “very strong capacity,” according to Fitch.

Globally, Fitch is considered the smallest of the “big three” rating firms which include Moody’s Investors Service and S&P.

How are government bonds rated?

Rating companies assess the financial strength of issuers including governments and give them credit scores ranking their ability to meet debt payments.

Investors often rely on credit ratings when purchasing bonds and their assessments can play a key role in determining how much interest a borrower pays to raise funds in capital markets.

Still, U.S. interest rates are held down by demand for the U.S. dollar, the world’s reserve currency and for U.S. Treasuries, which are considered the world’s benchmark risk-free asset.

Treasury Secretary Janet Yellen said in a statement after the rating cut that the move was “arbitrary and based on outdated data” and wouldn’t change investors views on U.S. government debt.

Still, the yield on 30-year bond had climbed to the highest in almost nine months before the rating was cut as the U.S. prepared to ramp up sales to fund a widening budget deficit.

What does it mean for markets?

When S&P cut the U.S. government’s credit rating in 2011, it fed into concern about the U.S. economy at a time when Europe was in the midst of a sovereign debt crisis.

Even so, the move had little long-term impact.

Investors poured into U.S. assets and government debt yields declined by year-end.

Part of that was because the U.S. economy was showing strength, while at the same time the European Union was struggling to safeguard its currency union.

This time around, financial markets are also concerned about the U.S. economy, but the focus is on the Federal Reserve’s most aggressive cycle of interest-rate hikes in decades to quell inflation.

In that sense, what the Fed does is likely to have a far larger bearing on U.S. interest rates than the Fitch rating cut. Moody’s still assigns the U.S. its top rating, which has become all the more important now after the Fitch downgrade.

What does this mean for other ratings?

The group of countries that still get top marks on their credit worthiness is a declining bunch.

Australia, Germany, Singapore, and Switzerland still have the top ratings from all three firms, according to data compiled by Bloomberg.

Fitch also rates Canada at AA+. China, the world’s second-biggest economy after the U.S., has an A+ score from the firm, three notches lower.

The sovereign’s rating can act as a ceiling on how high a company in that country is assessed but not in all cases.

The number of companies with a AAA level ratings from any of the big three assessors is a dwindling cohort, but it includes household names such as Microsoft and Johnson & Johnson.