Markets Brush Off US Debt Downgrade

By:

Dane Smith, Head of North American Investment Strategy and Research

Chris Carpentier, CFA, FRM, Senior Investment Strategist

Markets brush off Moody’s US debt downgrade, signaling resilience. But rising rates and fiscal strain still pose long-term risks for investors.

US debt levels have risen to concerning heights, prompting increased scrutiny from economists and policymakers. Despite widespread political awareness of the issue, current indications suggest that government spending will be maintained or even slightly increased, rather than curtailed. Although the United States continues to hold a high-quality debt rating, the growing debt burden may lead to higher risk premia, ultimately increasing the cost of borrowing.

The graph shows US Debt Chart for 20250603
A snapshot of Weekly Highlights by SSGA for 20250603

Markets Shrug Off a Well-telegraphed US Debt Downgrade

Last week, Moody’s downgraded US debt from AAA to Aa1. This move, while significant, was generally already expected and not much of a surprise. Other ratings agencies had made similar adjustments in the past; S&P downgraded US debt back in 2011, and Fitch followed suit more recently in 2023. Despite the downgrade, the market reacted calmly. The 10-year yield barely moved, and the S&P 500 index saw a slight increase of 0.09% on the first trading day after the news.

The market’s muted response suggests that investors had already priced in the downgrade. However, this event continues to highlight concerns about elevated debt levels and their potential implications on the appropriate term premia across the yield curve. As illustrated in the Chart of the Week, US debt levels remain high, hovering around 120% of GDP. This is a stark reminder of the fiscal challenges facing the country.

One major difference between now and the 2010s is higher interest rates. The cost of financing this debt is increasing, adding another layer of complexity to the fiscal landscape. While the new spending bill is still being finalized, early indications suggest that reducing the debt load is not a priority, and debt levels are expected to remain high.

The upward pressure on yields has significant implications for asset allocators over the long term. Higher yields make bonds more attractive compared to equities, potentially shifting the balance in investment portfolios. Higher yields also mean higher costs for financing corporate operations, which pressures corporate earnings and acts as a headwind for both equities and corporate credit spreads.

The graph shows 1yr Rolling Correlation for 20250603

Moreover, the concurrent price behavior of equities and bonds, which have exhibited a negative correlation over the past 20 years, tends to break down at higher yield levels. This negative correlation is a cornerstone of many asset allocation strategies, particularly during times of market volatility. If interest rates remain high, the reliability of this negative stock/bond correlation diminishes, making the role of other diversifiers even more critical.

Overall, we continue to believe that interest rates will be lower over the medium to long term. However, we do not dismiss the impacts of heavy debt loads and continued fiscal deficits. These factors will undoubtedly play a role in shaping the economic landscape and influencing investment decisions.

While the market has taken the recent downgrade in stride, it serves as a reminder of the ongoing fiscal challenges and the potential implications for investors. Elevated debt levels, higher interest rates, and the evolving dynamics between equities and bonds are all factors that need to be carefully considered in the context of long-term investment strategies.

Originally posted on May 26, 2025 on SSGA blog

PHOTO CREDIT: https://www.shutterstock.com/g/Wlliam+Potter

VIA SHUTTERSTOCK

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