U.S. credit rating at risk of Fitch cut on debt limit impasse
May 25, 2023 Updated Thu., May 25, 2023 at 4:51 p.m.
The tension around the U.S. debt limit negotiations ratcheted up after Fitch Ratings warned the nation’s AAA rating was under threat from a political standoff that’s preventing a deal.
Fitch may downgrade its assessment to reflect the increased partisanship that is hindering a resolution despite the fast-approaching so-called X date, it said, referring to the point at which Washington runs out of cash.
It moved the U.S. to “rating watch negative” under its classification. Meantime, DBRS Morningstar placed the U.S. ratings of AAA under review “with negative implications.”
Markets have been showing increasing nervousness over the standoff, with Treasury-bill yields slated to mature early next month surging past 7%, while the S&P 500 Index has declined for two days.
Economists project a U.S. default could trigger a recession, with widespread job losses and a surge in borrowing costs.
Fitch’s warning “underscores the need for swift bipartisan action by Congress to raise or suspend the debt limit and avoid a manufactured crisis for our economy,” said Lily Adams, a Treasury spokesperson.
The DBRS Morningstar adjustment “reflects the risk of Congress failing to increase or suspend the debt ceiling in a timely manner,” the statement said.
“If Congress does not act, the U.S. federal government will not be able to pay all of its obligations,” they said.
The cost of insuring U.S. sovereign debt against default with derivatives has risen, and Fitch’s statement also casts the spotlight on other rating agencies to see how they might react.
A White House spokesperson said the report demonstrated the urgency of reaching a speedy resolution.
“The worst-case scenario would be if the showdown leads to the government missing a debt payment for the first time, which might result in a widespread or lasting downgrade to the credit rating of U.S. Treasuries,” said Nikolaj Schmidt, chief global economist at T. Rowe Price.
“So many assets are priced in direct relation to U.S. Treasuries that the turbulence from a more pronounced downgrade would be felt in markets worldwide.”
In 2011, S&P Global Ratings drew fire for downgrading the U.S. from AAA after a similar brush with default.
That spurred a sell-off in risk assets like equities around the world, but ironically boosted Treasuries as investors sought out havens.
Strategists at JPMorgan Chase and Morgan Stanley have warned that an impasse threatens the outlook for equity markets, while traders have also piled into swaps and options for major currencies to hedge their portfolios.
PGIM Fixed Income says the U.S. will find itself in a similar impasse all over again, and has bought long-dated credit default swaps on that basis.
The yen, a traditional haven currency, spiked as traders reacted to the Fitch news before reversing gains.
Benchmark 10-year Treasury yields hovered around their highest in more than two months on expectations that interest rates may continue to rise even as the debt ceiling issue drags on.
“The hawkish re-pricing of Fed rate hike expectations has not been interrupted in recent days by the lack of progress made by U.S. officials over raising the debt ceiling,” Lee Hardman, a currency strategist at MUFG Bank, wrote in a note.
Still, it’s not unusual for Congress to strike deals at the last minute when the pressure becomes big enough to force negotiators to make painful choices.
“We believe risks have risen that the debt limit will not be raised or suspended before the X-date and consequently that the government could begin to miss payments on some of its obligations,” Fitch said. “Prioritization of debt securities over other due payments after the X-date would avoid a default.”
The company said it still expected a resolution. Failure leading to a debt default would however lead Fitch to cut affected debt securities to a D rating, with others downgraded to CCC and C.
House Speaker Kevin McCarthy expressed optimism Wednesday that White House and GOP negotiators would reach a deal in time to avert a potentially catastrophic default.
He said on Thursday that there were still a couple of issues remaining and negotiators will need to work 24/7 to get a deal done.
The California Republican’s comments came after a four-hour meeting between his and President Joe Biden’s handpicked negotiators, fueling optimism Congress will act before June 1, the date by which Treasury Secretary Janet Yellen has warned the U.S. could run out of money to pay its bills.
Moody’s Investors Service, which has the U.S. at a AAA rating with a stable outlook, hasn’t made any adjustments in wake of the wrangling in Washington to lift the nation’s borrowing capacity.
The firm’s base case is also that a deal will be made before the x-date.
S&P has also retained a stable outlook on the rating during the latest fracas, long anticipating that Congress would ultimately raise the debt ceiling before the Treasury lost its ability to fully fund the government.
The firm continues to stand by that view as last presented in a March 16 report, a spokesperson said Thursday.
The Fitch warning is “certainly very symbolic, and in a way it may force Moody’s to follow suit,” said Vishnu Varathan, head of economics and strategy at Mizuho Bank in Singapore.
“It will also place more scrutiny on the dollar and Treasuries as havens and its risk-free rate qualities.”
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