In a striking turn of events, the United States has experienced a significant downgrade in its credit rating, as announced by Fitch Ratings, one of the three major rating agencies. This downgrade sees the long-term foreign-currency debt rating fall from the coveted AAA status to AA+. Such a move has substantial implications for the U.S. economy and the global financial market, especially considering the recent increase in the scale of U.S. Treasury bond issuances. Investors have seen a swift rise in U.S. bond rates as a consequence of this shift, marking a notable period of volatility.

Since March this year, U.S. stock markets have seemingly thrived, with major indices like the S&P 500 and Nasdaq experiencing consistent climbs, even in the face of ongoing interest rate hikes from the Federal Reserve and turbulence within the banking sector. As of now, the S&P 500 and Nasdaq have recorded a five-month streak of positive performance, boasting year-to-date increases of 16% and 33% respectively. Yet, as the calendar flipped to August, this bullish momentum encountered turbulence, creating a dual impact on the stock and bond markets.

The immediate trigger behind this unrest was the statement from Fitch, highlighting concerns about the deterioration of America’s fiscal situation and increased government debt burden. Fitch's downgrade is their first adjustment of the U.S. debt rating and follows a similar action by Standard & Poor’s in August 2011. Analysts cite that the downgrading reflects expectations of worsening fiscal conditions over the next three years, with projections of continually high levels of debt. Indeed, during the COVID-19 pandemic, the U.S. embarked on extensive financial rescue efforts, leading to soaring budget deficits. The federal budget deficit soared to 14.9% and 11.9% of GDP in 2020 and 2021, respectively, starkly contrasting the situation following the 2008 financial crisis. Although the deficit was reduced in 2022, Fitch's outlook suggests that it is likely to remain above 6% for the foreseeable future.

Interestingly, during the 2011 downgrade, Treasury bond rates fell and the dollar strengthened as investors sought safe havens amidst declining global risk appetites. However, this time around, the market's reaction was entirely different. U.S. bond rates surged, and the dollar depreciated, suggesting a more challenging environment for U.S. debt instruments. A contributing factor to this is the looming issuance of over $1 trillion in new bonds by the Treasury—a provision anticipated to disrupt the bond market supply dynamics.

The evolving landscape also highlights that many emerging markets are shedding their holdings of U.S. Treasuries, resulting in diminished market liquidity. Japan’s recent monetary adjustments have sparked concerns about the potential ramifications for demand for U.S. debt as well. In the midst of these developments, analysts suggest that the current supply shock may only temporarily disrupt bond prices rather than change the overarching market trends, especially as the Fed's cycle of interest rate hikes nears its conclusion, indicating a potential downward trend for U.S. bond rates overall.

Fitch's downgrade has intensified discussions about governance issues in the U.S., particularly the recurring political stalemates over the debt ceiling. Despite the recent resolution to increase the debt ceiling, concerns linger about the re-emergence of such political impasses, impacting investor confidence in U.S. fiscal management. Fitch noted a troubling trend of governance deterioration over the preceding two decades, characterized by repeated debt ceiling throttles that conclude only at the last moment. This situation could severely undermine public trust in the ability for robust fiscal governance.

Comparisons with the 2011 downgrade by Standard & Poor’s are inevitable, particularly given the stalemate over the debt ceiling that was concurrent at that time. The S&P’s downgrade led to significant market volatility, with U.S. equities plummeting by more than 15% within a short timeframe. Then, investors flocked to bonds and gold, driving up bond prices and currency values. Yet, the economic climate of the time was markedly more dire, as Europe was grappling with sovereign debt crises that accentuated fears of another downturn for the U.S. economy, prompting the Fed to intervene swiftly.

In contrast, today’s economic outlook may be more stable. Analysts argue that this Fitch downgrade occurs well after the debt ceiling crisis, distancing itself from immediate political ramifications and ongoing market liquidity appears more favorable than a decade ago. Consequently, the immediate impact of the downgrade might be limited, with market fundamentals demonstrating more resilience compared to 2011.

In the short term, the rapidly escalating Treasury issuance is necessary to bolster the Treasury General Account (TGA) after the utilization of reserve funds during the debt ceiling standoff. The TGA account's balance has climbed from about $23 billion in June to an anticipated $650 billion by the end of September, prompting the Treasury to unveil a refinancing plan projecting a net debt issuance of roughly $1 trillion for the third quarter, exceeding earlier forecasts.

Such an increase in bond supply is likely to exert downward pressure on bond prices and consequently cause yields to rise further, especially since the bulk of the bonds issued focus on medium and long maturities, having a more pronounced market impact. However, the question arises: who will step in to absorb this deluge of U.S. debt? Major holders of U.S. Treasury bonds include the Federal Reserve, foreign central banks, investment firms, and mutual funds, with the Federal Reserve holding a significant stake of about 40%.

The Fed's existing policy of balance sheet reduction complicates their opportunity to act as the principal buyer in this situation. Moreover, foreign investors are also retracting their support for U.S. debt compared to previous years, spurred by rising geopolitical tensions and trends toward de-globalization. For instance, Russia has nearly liquidated its U.S. debt holdings, while Saudi Arabia has begun a noticeable reduction. Even Japan, traditionally a reliable holder of U.S. bonds, has scaled down its investments over the past year.

The Bank of Japan’s adjustments have emerged as a significant driver of rising U.S. bond rates. If Japan were to conclude its ultra-loose monetary policy, increased capital flows from Europe and the U.S. back to Japan could potentially exacerbate the climbing yields of U.S. bonds.

It is crucial to note that a downgrade in rating should not equate to a higher risk of default for U.S. Treasuries. The current supply-demand mismatch may not sustain itself over time. After the latest spike, U.S. bond yields show signs of overshooting, suggesting limited room for further increases, settling around 3.8%. However, before any significant prospects of interest rate cuts materialize, a sharp decline in bond yields appears improbable.

Nevertheless, the financial burdens on the U.S. government, already pressed for resources post-pandemic, become increasingly untenable amid rising interest expenses due to the Fed's ongoing tightening. Consequently, the U.S. Treasury will likely need to maintain substantial debt issuance over the long term as a means of addressing revenue shortfalls. Whether the fiscal deficit can revert to a more manageable percentage remains in considerable doubt, given that it took nearly five years following the 2008 financial crisis for the deficit to normalize. This time, it may take even longer, implying that annual net debt issuance exceeding $1 trillion could become a common theme for the U.S. Treasury in the coming years.