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Markets and economy

Vanguard's perspective on the U.S. credit downgrade

For only the second time in history, the U.S. credit rating has been downgraded. We discuss the ramifications.
5 minute read
August 03, 2023
Markets and economy
Market volatility
US treasury bonds

In early June, the United States avoided an unprecedented debt default but not—it turns out—a credit-rating downgrade. That arrived on August 1, when for only the second time in its history, the U.S. saw its credit rating downgraded. Fitch Ratings lowered the U.S. government’s long-term credit rating from AAA to AA+. Vanguard’s investment and thought leaders encouraged investors not to overreact.

"As the markets digest the news of the downgrade, we can expect some volatility," said Roger Aliaga-Díaz, Vanguard's chief economist for the Americas and head of portfolio construction. "The question is if a U.S. credit rating that is now lower than that of countries like Luxembourg and Singapore—and about on par with Finland and New Zealand—is appropriate, given the global safe-asset status of U.S. debt."

But he and other Vanguard leaders say the downgrade’s impact will likely be minimal.

"The near-term ramifications for the U.S. of a credit-rating downgrade are relatively minor," said Roger Hallam, global head of rates for Vanguard Fixed Income Group. "Investors still perceive the U.S. as having a strong willingness and ability to fulfill its obligations."

In lowering the U.S. credit rating, Fitch cited a trio of factors: ". . . expected fiscal deterioration over the next three years, a high and growing general government debt burden, and the erosion of governance relative to 'AA' and 'AAA' rated peers over the last two decades."

U.S. credit downgrade by S&P, in 2011, did not have long-lasting consequences

The last time a credit-rating agency downgraded U.S. debt was in 2011, when Standard & Poor's downgraded the government's rating from AAA to AA+. Then, as in the spring of 2023, Congress and the White House reached an agreement to raise the debt ceiling only days before the Treasury would have exhausted its cash reserves.

"There was turmoil in both the equity and fixed income markets back then, but that was more due to the debt ceiling impasse rather than from the credit downgrade itself," said Aliaga-Díaz. "The market impact of Fitch's rating action may not be clear immediately, but it’s worth noting that the credit downgrade in 2011 didn’t have long-lasting consequences. Moreover, after the 2011 downgrade, investors flocked to U.S. Treasuries, pushing yields down slightly, not up. Global investors, institutions, and foreign governments all rely on Treasuries. As of now, there are few alternatives to Treasuries as a way to invest in the world’s reserve currency, which is the U.S. dollar."

That said, yields could stay higher for a longer period.

U.S. fiscal challenges could be reflected in higher yields

"The downgrade does highlight some medium-term challenges for the U.S. fiscal outlook," Hallam said. "If these challenges are left unaddressed, it is possible that investors could start to demand a higher risk premium of the U.S. Treasury's borrowing costs."

Whatever the full ramifications on the markets and the economy, both leaders expressed the need for investors to stay the course and not try to time the markets.

"Investors should not try to time the markets' reactions to shocks such as this downgrade on U.S. debt," Aliaga-Díaz said. "They should keep their eyes on their medium- or long-term investment goals, while trusting that portfolio diversification can smooth some of the choppiness in the markets.

"For investors that prefer a more active approach around macro events, a valid alternative could be to add a trusted active manager to their portfolio and rely on her professional judgment to navigate risks or even find prudent opportunities amid the confusion."

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