Written by: Eric Bank
Edited by: Lillian Guevara-Castro
Reviewed by: Adam West
Key Takeaways
- Moody's has lowered the U.S. rating from Aaa to Aa1, blaming increasing debt and political dysfunction. The change could translate into higher borrowing costs throughout the economy.
- Treasury yields jumped straightaway, reflecting heightened investor anxiety as well as the possibility for rates on mortgages, auto loans, and credit cards to go up.
- Subprime lenders and card issuers could experience tighter margins and higher funding costs, perhaps leading to stricter underwriting and higher APRs.
The U.S. government has suffered another loss in its fiscal credibility. Moody’s recently downgraded the rating on the United States’ sovereign debt from Aaa to Aa1. Now, no major agency assigns the U.S. its best rating — Standard & Poor’s downgraded in 2011, Fitch in 2023, and now Moody’s joins them.
Although the downgrade may be symbolic, it is already having real consequences.
On the Monday after the downgrade, Treasury yields rose: the 30-year passed 5% (the highest it reached since late 2023), the 10-year reached 4.5%, and the 2-year reached 3.99%. Increasing Treasury yields translates into higher debt for all consumers and businesses as well.
What the Downgrade Indicates for the Credit Market
Treasury bonds represent the foundation of finance worldwide. When their reputation for being safe is undermined, the effects flow out in all directions.
- Benchmark rates go up: As the yields increase, the cost of capital goes up along with them. It influences anything from business loans to securitization transactions.
- Consumer borrowing rates increase: Credit card APRs, now standing at 20.12%, as reported by Bankrate, may get higher. Mortgage rates, currently at 6.81% for a 30-year fixed-rate loan (according to Freddie Mac), may increase as well.
- Lender tightening: In response to macro risk and rising costs, lenders tighten standards and decrease approvals.
- Market sensitivity increases: As observed by Callie Cox of Ritholtz Wealth Management, Moody’s downgrade came “at a wildly inopportune time for the fixed-income market,” when uncertainty among investors about U.S. debt and long-term Treasuries reached its peak.
Subprime lenders are particularly vulnerable. They often rely on securitization funding or wholesale lines of credit, both of which become costlier when U.S. debt appears riskier.
The Government’s Credit Score Parallels That of Consumers
Moody’s rationale for the downgrade parallels the rationale for consumer credit scores. When consumers accumulate too much debt, miss payments, and have no strategy for repayment, lenders punish them with low scores. The U.S. is not missing payments, but it is following a path that worries Moody’s.
The U.S. has not managed its rising deficits and interest expenses, says Moody’s. Entitlement spending will climb while revenues remain flat.
Unless there is significant fiscal reform, the government debt burden will continue rising. That deterioration — compared to its own history and compared with its peers — is why the downgrade occurred.
Looking back, the downgrade could be the end of an era in which the U.S. borrowed at will without causing investor outrage. The presumption that an unlimited amount of borrowing was available has collided with the reality that risk premiums are on the increase.
What Comes Next for the Industry
While markets haven’t panicked, experts are monitoring closely. Moody’s underscored that there is no clear-cut plan in place to change America’s trajectory of debt, and recent political action implies that further spending is in the pipeline.
The Wall Street Journal stated that the House Budget Committee recently passed forward a spending-and-tax proposal estimated to increase the deficit by trillions. In the words of Deutsche Bank strategist Jim Reid, “There are no signs of any serious deficit restraint at this stage.”
Axios observed that the new bill comes on the back of high debt and interest rates — whereas past deficit-expansion policies were enacted in more indulgent financial times. Such timing may increase investor worries.
For the lending business, it presents multiple challenges:
- Increased pricing pressure: Issuers should consider increasing APRs to cover rising funding costs.
- Underwriting changes: Stricter requirements may hamper originations, particularly in the subprime market.
- Margin squeeze: Increasing the cost of funds can squeeze profit for smaller lenders.
- Reduced policy flexibility: Moody’s noted that the U.S. may now have fewer budgetary resources available to respond to upcoming recessions or crises, putting systemic risk higher.
The U.S. downgrade highlights how delicate the financial system is against growing debt and political upheaval. For an economy that runs on predictability and stable benchmarks, even a one-notch downgrade can rattle the entire system.
As Callie Cox put it, “The government deficit isn’t a problem until investors think it is. And they’re increasingly telling us that the deficit is a problem.”
