What does the US debt downgrade mean?

Fast reading

At the end of last week, Moody’s stripped the US of its triple-A credit rating for the first time in over a century.
Long-term US borrowing costs rose in the wake of the announcement and a weaker-than-expected US Treasury auction seemed to confirm investor concerns over its rising debt burden.
However, a number of factors point to a more favourable US growth environment in the second half of the year.

Investors have been processing Moody’s decision to downgrade the US credit rating late last week, stripping the world’s largest economy of its last ‘perfect’ credit score.

Moody’s cut its US sovereign credit rating from Aaa to Aa1 on 16 May, citing concerns about rising levels of government debt and the country’s widening budget deficit. (Agencies Fitch and S&P stripped the US of its top rating in 2023² and 2011³.)

Moody’s warned that the proposed extension of the 2017 Tax Cuts and Jobs Act could be expected to add around US$4tn to the US deficit. The extension cleared the Republican-controlled House of Representatives on Wednesday.

“Despite high demand for US Treasury assets, higher Treasury yields since 2021 have contributed to a decline in debt affordability,” Moody’s said in a statement.

“While we recognise the US [has] significant economic and financial strengths, we believe these no longer fully counterbalance the decline in fiscal metrics,” the agency said.

Long-term US government borrowing costs crept higher following the downgrade. The 30-year Treasury yield climbed above 5% for the first time since October 2023, while the 10-year Treasury yield rose to around 4.6%⁴.

The US Treasury saw weaker demand for US$16bn in 20-year bonds in an auction on Wednesday. Yields were up from 4.81% at the previous auction to 5.05% – the highest since 2020⁵.

Figure 1: US downgrade drives up borrowing costs

The US economy is experiencing a slowdown, not a recession.

The announcement sent further ripples throughout the financial system, with Moody’s then electing to downgrade the long-term ratings of US lenders JPMorgan Chase, Bank of America, and Wells Fargo on Monday⁶. The agency justified the decision on the basis that the US government’s ability to support systemically important banks has weakened.

Karen Manna, Portfolio Manager and Investment Director of Fixed Income at Federated Hermes, says it remains to be seen whether the downgrade will have long-term repercussions for the US economy:

“With the focus on policy making in Washington DC, the tension between hard and soft data continues, as the drumbeat of change and negative headlines spurs caution. The Moody’s downgrade will likely push the US Treasury yield curve higher and steeper in the short run, but consumers and companies will have to move from a nervous hold to outright wallet tightening and layoffs to prompt a greater macro shift,” she says.

However, Steve Chiavarone, Head of Multi Asset Group at Federated Hermes, remains optimistic about the outlook for the US over the rest of the year.

“As uncertainties related to the tariff programme fade and new fiscal measures are introduced, a more favourable environment for growth should become evident in the second half of the year,” he says.

“The US economy is experiencing a slowdown, not a recession, and US consumer resilience and low unemployment figures suggest recession risks remain low.”

Chiavarone expects US equities to outperform in the second half of the year, led by large-cap tech and small and medium-sized (SMID) caps, which should benefit from domestic tailwinds, he says.

“Financials and overlooked tech names offer compelling value. For global investors, a 30-50% US equity allocation balances opportunity with diversification. Despite political noise or short-term underperformance, the US remains a hub for innovation and growth, and global investors will continue to seek exposure to that,” he adds.