Fitch move spotlights US debt risk as Recession fear fades

The move by Fitch Ratings to downgrade US government credit has put a renewed focus on the nation's debt trajectory, just when the world's largest economy is shaking off forecasts for a looming recession.

In the past week, Chairman Jerome Powell said the Federal Reserve is no longer expecting a US downturn, even after the most aggressive interest rate hikes in decades, and economists at Bank of America Corp. also scrapped their recession forecast. Evidence of enduring strength among consumers and businesses keeps coming in: Data released Wednesday showed US companies added more jobs in July than expected.

That's all a stark contrast to 2011, when S&P Global Ratings stripped the US of its AAA rating. Back then, the economy was hauling itself out of the global financial crisis and unemployment was around 9%. It's now at 3.6%, near the lowest level in decades.

The decision by Fitch to lower the US sovereign credit grade one level from AAA to AA+ highlights the debt pile that the US has built up in recent years, largely due to pandemic stimulus as well as tax cuts. More recently, the government has also launched investment programs for infrastructure, technology and clean energy. Meanwhile the cost of borrowing has soared as the Fed pushed interest rates to a 22-year high.

Fitch forecasts US debt to reach 118% of gross domestic product by 2025, about three times higher than the median of 39% among countries awarded the top-of-the-class AAA rating. It projects that the ratio will rise even higher in the longer term. That could set up tough decisions for future administrations in the White House, analysts say.

"Ultimately, if the deficit isn't contained, taxes will be raised to the point that the engine of the US economy — the all-important consumer — will have considerably less discretionary income," said Quincy Krosby, chief global strategist for LPL Financial.

'Arbitrary' Downgrade

The US budget deficit surged to record levels when the government spent heavily to support households and businesses as Covid shut down the economy. It shrank last year, but now it's widening again.

The federal deficit hit $1.4 trillion for the first nine months of the current fiscal year, almost triple the year-earlier figure. The US Treasury this week boosted its borrowing forecast for the current quarter to $1 trillion, well above the $733 billion it had predicted in May.

"The daily Treasury data through the month of July showed a pretty weak pattern for receipts," said Michael Englund, chief economist at Action Economics LLC.

Fitch's downgrade is a signal that the US needs to get its budgetary process in order ahead of what looks like another political fight this fall, and possibly another government shutdown, said Mike Skordeles, head of US economics for Truist Financial Corp. Lawmakers in June struggled to agree on lifting the government's debt ceiling, though they eventually did.

The US deficit has been growing for years, with little progress over multiple presidential administrations, and Fitch is saying to politicians of both parties that "neither one of you has the political will to do it," Skordeles said.

Treasury Secretary Janet Yellen called the downgrade "arbitrary" and "outdated." Yellen has argued that rather than looking at debt-to-GDP, a better measure of sustainability is inflation-adjusted interest payments as a share of the economy — and that metric hasn't been flashing warning lights.

The ratings agency is still forecasting a mild recession in the US in the fourth quarter this year and first quarter of 2024, according to Richard Francis, Fitch co-head of Americas sovereign ratings, who spoke in a Bloomberg TV interview Wednesday.

The downgrade decision looked through the forecasts for a recession. James McCormack, global head of sovereign and supranational ratings for Fitch Ratings, said in an emailed response to questions that the downgrade was based on the medium-term fiscal outlook, "which is characterized by rising deficits and government debt," rather than predictions of a potential recession.

He added that Fitch is "not confident in policy measures being agreed and implemented to address the fiscal deterioration."

Many market participants share that view. UBS Group AG strategists say the underlying conditions that led to Fitch's decision are worse than the ones that underlay S&P's similar move more than a decade ago.

"The 2011 downgrade was primarily caused by debt ceiling posturing," strategists led by Michael Cloherty wrote in a note Tuesday. "This downgrade was caused by both debt ceiling risks and by very large budget deficits."

Disclaimer: This article first appeared on Bloomberg, and is published by special syndication arrangement.