America's Credit Rating Was Just Cut: Now What?

On August 1, Fitch Ratings, one of the three primary credit rating agencies, downgraded the United States' long-term credit rating from AAA to AA+, the second downgrade of U.S. debt in 12 years. In August 2011, Standard and Poor's (S&P) downgraded U.S. debt in response to deficit spending and policies it believed "fell short of the amount necessary to stabilize the general government debt burden." In its recent downgrade, Fitch stated: "The repeated debt-limit political standoffs and last-minute resolutions have eroded confidence in fiscal management."

The verbiage of both was harsh, but the downgrades were arguably mild. A downgrade from AAA to AA+ is roughly the institutional equivalent of a drop in an individual's FICO score from 850 to 830. The credit is still excellent, and the slight drop should not materially impact borrowing costs. However, the warnings in the report should not be ignored, and there is a very good case to be made that the AA+ rating is overly generous.

The current U.S. debt-to-GDP ratio is roughly 120%. That is three times higher than the global AAA median of 39.3%, and it's more than double the median of other AA-rated countries. Fitch was only this generous with its credit rating because of its recognition of the unique financial benefits the U.S. dollar enjoys as the global reserve currency. Fitch forecasts additional debt/GDP growth, "increasing the vulnerability of the U.S. fiscal position during future economic shocks."

Why should we care?

In 2011, the government's cost of borrowing counter-intuitively fell after the S&P downgrade. After the Fitch downgrade this year, yields initially moved higher before stabilizing. Treasury yields, however, remain elevated and volatile.

If downgrades don't impact borrowing costs, why should we care? The answer lies in the warnings and forecasts in the Fitch and S&P reports. The U.S. financial condition is worse than the AA+ credit rating would suggest and continues to deteriorate. According to the Bureau of Economic Analysis (BEA), the government collected $7.6 trillion in total receipts and had $9.1 trillion in expenditures, resulting in $1.47 trillion in net borrowing (the deficit) in 2022. Forecasts for 2023 put net borrowing even higher. Fitch was right to be concerned. This level of deficit spending is usually only seen in times of war or deep recession. Currently, the economy is growing with low unemployment. Should that change, the report specifically noted "increasing vulnerability ... to future economic shocks."

Not only is the government borrowing more, but the cost of that debt is much higher. For much of the 21st century, the government was able to borrow at interest rates near 1%. Now, thanks to inflation, borrowing is at 5% or higher. Higher interest expenses result in more government expenditure, which results in even more deficit spending, which requires even more borrowing. We can quickly see the issue here.

Trillions of dollars are hard to comprehend, so let's compare the federal budget to a household budget. Imagine a household with $76,000 in take-home pay spending $91,000 per year with the $15,000 debt going on a credit card every year for the foreseeable future. The credit card balance is currently $330,000 (and growing each year) with an interest rate that tripled in the last 18 months. This debt can't be discharged in bankruptcy, so the children and relatives are responsible for paying it off. Do you think that household would still enjoy an 830 FICO score?

So, what happens when the government runs out of money? This is where the global reserve currency status is so valuable because the government can just create more. Technically, this is not allowed, but the Treasury and Federal Reserve have developed a workaround via open-market operations. This new money comes at a cost though. When you create money faster than you grow GDP, you have more dollars chasing fewer goods, resulting in higher prices. Contrary to modern monetary theory, 2020-22 has shown us that inflation is a predictable result of excess money creation.

In many ways, our status as the global reserve currency has allowed the U.S. to operate well beyond traditional financial constraints. Unlike many financial doomsayers, I don't believe that we are immediately at risk of losing our reserve currency status. Yes, the euro was built to compete with the dollar, but the European Union is too weak and fragmented to effectively compete. China and Russia are trying to put together a BRICS alternative to the U.S. dollar, but authoritarian economies eventually revert to control over the freedom and legal protections necessary to be a reserve currency.

What can you do to protect your assets?

The U.S. has its fiscal issues, but currency value is a relative game, not an absolute one. No other country or union has the size, liquidity, and stability of the United States. The threat is not a collapse of the dollar, but a consistent and potentially accelerating loss in purchasing power and the erosion in quality of life as inflation consumes more and more of our discretionary budget.

To protect your purchasing power, consider buying assets that have positive cash flows. Stocks and income-producing assets can have earnings that can grow in nominal dollars, meaning that as inflation grows, so does your cash flow and eventually the assets' value. You should also consider assets that cannot be duplicated — physical gold, premium real estate, and even fine art. Know that some of these suffer from limited liquidity and unique storage challenges.

Many argue that crypto serves as a hedge against currency dilution. Again, the "cannot be duplicated" criteria apply here. One could argue that Bitcoin has value because of its known scarcity and broad acceptance, while other random coins are of little long-term value.

Investors need to recognize that the entity issuing the U.S. debt also makes the rules of commerce. The government has a vested interest in supporting its spending needs; therefore, protecting your purchasing power requires constant diligence.

The information provided here is not investment, tax, or financial advice. You should consult with a licensed professional for advice concerning your specific situation.