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 agenciesThis 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.Seconomy and the global financial market, especially considering the recent increase in the scale of U.STreasury bond issuancesInvestors have seen a swift rise in U.Sbond rates as a consequence of this shift, marking a notable period of volatility.

Since March this year, U.Sstock 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% respectivelyYet, 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 burdenFitch's downgrade is their first adjustment of the U.Sdebt 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 debtIndeed, during the COVID-19 pandemic, the U.Sembarked on extensive financial rescue efforts, leading to soaring budget deficits

• Dollar Index Soars
• Significant Depreciation of the Won
• Decline in European Corporate Profits
• Decline in U.S. Treasury Yields
• Wall Street Banks Seek Transparency

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 crisisAlthough 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 appetitesHowever, this time around, the market's reaction was entirely differentU.Sbond rates surged, and the dollar depreciated, suggesting a more challenging environment for U.Sdebt instrumentsA 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 liquidityJapan’s recent monetary adjustments have sparked concerns about the potential ramifications for demand for U.Sdebt as wellIn 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.Sbond rates overall.

Fitch's downgrade has intensified discussions about governance issues in the U.S., particularly the recurring political stalemates over the debt ceilingDespite the recent resolution to increase the debt ceiling, concerns linger about the re-emergence of such political impasses, impacting investor confidence in U.Sfiscal managementFitch 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 timeThe S&P’s downgrade led to significant market volatility, with U.Sequities plummeting by more than 15% within a short timeframeThen, investors flocked to bonds and gold, driving up bond prices and currency valuesYet, 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.Seconomy, prompting the Fed to intervene swiftly.

In contrast, today’s economic outlook may be more stableAnalysts 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 standoffThe 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.Sdebt? Major holders of U.STreasury 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 situationMoreover, foreign investors are also retracting their support for U.Sdebt compared to previous years, spurred by rising geopolitical tensions and trends toward de-globalizationFor instance, Russia has nearly liquidated its U.Sdebt holdings, while Saudi Arabia has begun a noticeable reductionEven Japan, traditionally a reliable holder of U.Sbonds, 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 ratesIf Japan were to conclude its ultra-loose monetary policy, increased capital flows from Europe and the U.Sback to Japan could potentially exacerbate the climbing yields of U.Sbonds.

It is crucial to note that a downgrade in rating should not equate to a higher risk of default for U.STreasuriesThe current supply-demand mismatch may not sustain itself over timeAfter the latest spike, U.Sbond 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.Sgovernment, already pressed for resources post-pandemic, become increasingly untenable amid rising interest expenses due to the Fed's ongoing tightening