The $25 Trillion Treasury Market is in the Spotlight After the U.S Lost Its AAA Rating for the Second Time in a Row

Will August 2023 mimic the events of August 2011?

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On Tuesday, Fitch Ratings became the second major credit firm to downgrade the U.S. government's top AAA rating to AA+, eliciting swift condemnation from the White House and the Treasury Department.

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However, history suggests that the financial markets might respond differently than expected, possibly leading to a rally in the approximately $25 trillion market for Treasury securities.

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Chip Hughey, Managing Director of Fixed Income at Truist Advisory Service, noted the timing of the downgrade as a bit surprising. Comparing the current situation to the 2011 downgrade, Hughey highlighted that the immediate response in financial markets was not focused on the U.S. government's ability to meet its debt obligations. Instead, the reaction primarily revolved around potential economic growth concerns, which subsequently increased the demand for U.S. Treasurys, despite the downgrade.

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In 2011, S&P Global Ratings downgraded the U.S. credit rating to AA+ from AAA shortly after a debt-ceiling deal was reached in Washington.

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Fitch had previously indicated the possibility of such a downgrade, warning in May due to the debt-ceiling impasse and repeating its concerns in June after the U.S. reached a deal on its borrowing limit. The actual downgrade followed about a month later.

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During the 2011 downgrade, the 10-year Treasury yield declined from approximately 3% heading into August to about 1.8% in late September.

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Hughey emphasized that while the reaction this time may not mirror 2011 precisely, the current rating action could potentially alter the perception of U.S. creditworthiness. Nevertheless, the concerns cited by Fitch for the downgrade might also create anxieties in the market, leading investors to seek assets traditionally considered safe havens.

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Fitch's rating downgrade was attributed to "expected fiscal deterioration," a "high and growing" government debt burden, and an "erosion of governance" amid repeated debt-limit standoffs and other issues.

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Notably, short-term Treasury bill yields have climbed above 5% due in part to the Federal Reserve's efforts to combat inflation by quickly raising its policy rate. Last week, the Fed raised rates again, bringing its policy rate to a 22-year high, in the range of 5.25%-5.5%.

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Investors have been actively acquiring the influx of Treasury securities issued since the June debt-ceiling deal allowed U.S. coffers to be refilled, albeit at higher borrowing costs than in the recent past.

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Despite these events, stocks have shown a robust rally, trading around 5% off record highs. The Dow Jones Industrial Average (DJIA) increased 7.5% through Tuesday, the S&P 500 index rose 19.2%, and the Nasdaq Composite Index gained 36.5% in 2023, according to Trade Algo.

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Moody's Investors Service still maintains a top Aaa rating for the U.S. with a stable outlook.