Fitch downgrades U.S. Debt. How long before they do it again?

On Wednesday, Fitch downgraded the United States long-term credit ratings to AA+ from AAA. They gave it a stable outlook. AAA is the best possible credit rating. AA+ is one notch below that.

Ratings

Fitch's credit rating scale starts as follows:

AAA, AA+, AA, AA-, A+, A, A-, BBB+, BBB, BBB-, BB+, BB, BB-, CCC+...

The scale continues until it reaches "D" which is outright default.

In Fitch’s view, "there has been a steady deterioration in standards of governance over the last 20 years".

Outrage and Shock

Reaction from Washington was one of anger and disbelief from many sources. Janet Yellen, Secretary to the Treasury and former Federal Reserve Chairman, said the decision was "arbitrary and based on outdated data".

It's a good job Fitch didn't use the most recent data! Given her position, she used the right words, but it's probably not what she knows in her heart.

Investors don't care

There was mooted reaction from investors. The U.S. 10 Treasury bond yield inched up to 4.12% and U.S. stocks fell by 1.38%.

Public Finances out of control

Fitch gave multiple reasons for the downgrade, some of which have been discussed here by me and other Linkedin members.

In short the reasons cited included:

**Erosion of Governance**

**Rising General Government Deficits**

**General Government Debt to rise**

**Medium Term Fiscal Challenges Unaddressed**

**Economy to Slip into Recession**

The Fitch website goes into more detail for each of the above negative factors. For example Fitch sees the budget deficit continuing to increase as a percentage of GDP, and the interest burden also increasing as a percentage of GDP.

They point out that the government debt at 112.9% is already two and a half times the "AA" median of 44.7% of GDP.

Fitch's longer-term projections forecast additional debt/GDP rises, increasing the vulnerability of the U.S. fiscal position to future economic shocks.

Next move: Downgrade again

Fitch outlines the factors which could lead to a future upgrade or downgrade in the credit rating:

Upgrade:

Reducing spending or increasing revenues sufficiently to result in a medium term decline in the debt-to-GDP ratio.

Downgrade:

A marked increase in public debt. Failure to address medium term public spending and revenue challenges, and/or undermining of the reserve currency status of the U.S. dollar, thus diminishing the government's financing flexibility.

Where not to put your Money

As things stand, it looks like betting on a future upgrade would be like betting on a three legged donkey in a horse race full of sleek stallions.

Since the government's official plan is to continue to run budget deficits of increasing size, and to increase the debt to GDP ratio as a consequence, it looks like the next downgrade is inevitable. I'll give it a year.

I wouldn't invest in U.S. Teasuries.

Like a Teenager with an Unlimited Credit Card

As anyone who understands finance will know that the US Government has been living beyond its means for decades. It continues to spend more than it collects in taxes, borrowing the difference.

A decade ago, they at least had a plan to balance the budget, and start reducing the debt to GDP ratio. Never mind that the plan was half-baked. At least they had a plan.

Now that plan has gone out the window. The official U.S. budget sees spending continuing to increase faster than revenues. Under their own forecast, the debt to GDP ratio is set to continue increasing.... forever.

Forever is not going to happen - Here's how the game ends

If the government's future spending plans play out according to their own plans we will sooner or later reach the point where the interest payable on the national debt exceeds the tax revenues. That's like having a credit card where you keep spending and keep borrowing to pay off the previous month's debt, increasing you outstanding balance. Eventually due to the interest charge the monthly interest exceeds your salary. Game over.

**Outright default**. This is an unlikely scenario in my opinion. (see Greece 2015). Probability < 3%

**Rising inflation** The Federal Reserve steps in as lender of the last resort. It prints the money it lends to the government. Ultimately this leads to **Hyper-inflation** Nobody wants the currency. They'd rather own anything else. This is a possble but fairly unlikely sceanrio. (See Argentina 2023). Probability > 5%

**Bail-in". In a bail in, the government requires the holders of fiat currency or bank deposits to lend the money to the government at a rate determined by the government (See Brazil 1990). Another unlikely scenario. probabilty < 3%

**Controls**. This could include exchange controls, wage and price controls, restriction and what you can do with your money, prohibitions on hoarding, forced conversion of some assets, such as gold, into government currency etc (See Britain in the 1960s). Probability > 10%

**Dual Currency System" A new dollar is issued for day-to-day spending. Effectivley there are two currencies. Effectively it is like a domestic dollar and an international dollar. Restrictions are placed on what you can do according to the type of dollars you have. (See China CNY and CNH 2023, UK dollar premium system 1960s -1970s, Cuba CUP and CUC, 1970s to 2021). This is a possible scenario which would avoid a default. Probability > 20%

**Currency Reset**. In a currency reset, a new currency replaces the old one. This could happen in a crisis or war. Some holders of the old currency get to change some of their money to the new currency, but the large holders are told they have to wait. The old currency cannot be used for day to day spending or investment, meaning that it gradually becomes worthless. This is a possible scenario. (See East Germany 1990) Probability > 40%

**CBDCs**. With the introduction of the CBDC, the government has the control on what you can spend your money on, where, when, and how you can spend it. They can restrict how much of your old dollars you can convert into the new CBCD dolars at 1:1. In other words moving from old dollars to CBDCs is wholly or partially restricted. New government debt is issued in CBDC dollars which don't have the same restrictions as the old dollars. Probability > 40%

**Economic Miracle**. Something amazing happens which solves all the financial problems, thanks to technilogy or AI. (See California Gold Rush 1848). Probability > 5%

**Public Finances restored to order**. This would require large cuts in the non-discretionary spending such as social security. Probability <10%

In conclusion, if you are holding U.S. Government debt, it's unlikely to give you the value and protection you are seeking. Under several of the more likely scenarios (**Reset** and **CBDCs**), you will likely see a total loss of value of your fiat, deposits, money market funds and bonds, both governemnt bonds and corporate bonds.

I can't tell you when it will happen. It won't last ten years. A crisis can surge at any time. Black-Swan events happen all the time. The next one might be tomorrow, or next year but it's certainly coming. When it happens, that my be the excuse needed to reset things.

Don't be a bag-holder.

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