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Does the downgrade matter?

Key takeaways

  • The US government's credit rating has been lowered by ratings agency Fitch.
  • The downgrade reflects concerns about the growth of the government's debt and the ability of Congress and the administration to control spending.
  • Financial markets may experience short-term volatility as a result of the downgrade.
  • Bonds issued by the US Treasury remain among the safest investments despite the downgrade and Treasury yields may rise as a result.

Two months after the federal government narrowly avoided defaulting on its debt amid a highly partisan conflict in Congress, an unfavorable review of that drama is in. Credit rating agency Fitch Ratings has lowered its grade on the government’s debt from AAA to AA+ and says that it “expects fiscal deterioration over the next 3 years.” Besides that gloomy view of the near future, Institutional Portfolio Manager Lars Schuster says that Fitch’s action also “reflects its view that governance on fiscal and debt matters has steadily deteriorated over the last couple of decades.”

The downgrade moves the US out of the group of countries which hold the world’s highest credit ratings from Fitch, which is one of 3 firms that evaluate the ability of governments and companies to pay back interest and principal to investors who lend them money by buying the bonds they issue.

This is the second time the US government’s debt has been downgraded. The first downgrade took place in 2011, when credit rating agency Standard & Poor's cut the US credit rating from AAA to AA+, following a rancorous debate in Congress over the size of the debt. At the time, Standard & Poor's cited the growing deficit and the prolonged debate as reasons for the downgrade, much as Fitch has done 12 years later.

What's behind the downgrade

The fact that the federal government has suffered a second debt downgrade 12 years after the first one suggests that Washington’s lack of resolve to meaningfully cut spending is an ongoing concern for ratings agencies and investors alike.

When US debt was downgraded following the 2011 debt-ceiling agreement, one of the reasons ratings agencies gave was the failure of politicians to confront rising debts. Not so long ago, members of both political parties expressed concern about the impacts of government debt and spending. Many Democrats as well as Republicans supported a constitutional amendment requiring a balanced budget and from 1998 to 2001, congressional Republicans and a Democrat president produced balanced federal budgets.

But since then, deficit spending that higher debt makes possible has gained bipartisan support even in a highly polarized political environment. Research from Fidelity's Asset Allocation Research Team (AART) suggests that higher debt is not a recipe for faster economic growth, and that the responses by policymakers to that debt can ultimately lead to higher inflation and more volatile financial markets than in the past.

Publicly held US debt topped 120% of gross domestic product in 2022, according to the US Office of Management and Budget. That's a level of debt far greater than the average over the past 50 years. And the debt is projected to increase significantly in the future. The Congressional Budget Office (CBO) projects the federal budget deficit will total $13.1 trillion from 2023 through 2032.

AART believes the rise in debt is ultimately unsustainable. They say that historically, no country has perpetually increased its debt/GDP ratio. The highest levels of debt ever topped out around 250% of GDP. Since 1900, 18 countries have hit a debt/GDP level of 100%, generally due to the need to pay for fighting world wars or extreme economic downturns such as the Great Depression. After hitting the 100% threshold, 10 countries reduced their debt, 7 increased it, and one kept its level of debt roughly the same.

AART looks to these historical examples to consider what may happen in the US as public debt passes 100% of GDP. They expect political pressures for monetary and fiscal policymakers to take a more active role in the economy will lead to higher inflation in the future.

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What may the downgrade mean for stocks?

Stock markets generally react over time to changes in the pace of economic growth, and the direction of corporate earnings and asset prices, rather than political events. However, the chart below shows that US stock markets have historically turned volatile during periods of heightened concern about the fiscal wellbeing of the federal government.

Source: Daily data from Bloomberg Finance, L.P., 3/31/2023. US Department of the Treasury. Time periods are 90 days before and after deadlines to raise the federal debt ceiling.

Since 1985, the federal government has approached the limit of its ability to borrow more money to fund its activities on 12 separate occasions. Each time, stock prices experienced an increase in sharp movements up and down before eventually rising after the threat of a default on US Treasury securities diminished following an agreement to raise the debt limit. In 2011, however, when the federal government's credit rating was downgraded for the first time, volatility remained higher for longer than during similar periods of heightened concern about the government's ability to manage its finances.

What may the downgrade mean for bonds?

Despite the downgrade, the market for bonds issued by the US Treasury is still the largest and most liquid financial market in the world. Says Schuster, "This has not changed overnight. Investors looking for safety when things get choppy are still likely to turn to Treasurys."

The downgrade could also deliver some opportunity for income-seeking investors by pushing up the yields on Treasury bonds with longer maturities. Since 2022, Treasurys that mature further into the future have paid lower interest rates than ones that mature sooner. This unusual situation is called an inversion of the yield curve and has reduced the appeal of longer-term bonds for investors.

What can investors do about the debt?

Investors concerned that rising debt may cause higher volatility and lower growth in the future may want to consider further diversifying their portfolios by adding exposure to a wide variety of assets.

If you want to create a plan or refine your existing plan, try our online tools in the Planning & Guidance Center. Or for professional help, consider a Fidelity planning consultant.

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Standard & Poor's (S&P) credit ratings rank the creditworthiness of debt issuers, such as a corporation or government. The highest rating on the S&P scale is AAA and it reflects an extremely strong ability to meet financial commitments. One step down is AA, which reflects a very strong ability to meet financial commitments. There are 5 ratings considered investment grade: AAA, AA, A, BBB, BBB-. Fitch Ratings publishes credit ratings that are forward-looking opinions on the relative ability of an entity or obligation to meet financial commitments. Issuer default ratings (IDRs) are assigned to corporations, sovereign entities, financial institutions such as banks, leasing companies and insurers, and public finance entities (local and regional governments). Issue level ratings are also assigned, often include an expectation of recovery and may be notched above or below the issuer level rating. Issue ratings are assigned to secured and unsecured debt securities, loans, preferred stock and other instruments, Structured finance ratings are issue ratings to securities backed by receivables or other financial assets that consider the obligations’ relative vulnerability to default. Credit ratings are indications of the likelihood of repayment in accordance with the terms of the issuance. In limited cases, Fitch may include additional considerations (i.e., rate to a higher or lower standard than that implied in the obligation’s documentation). Please see the section Specific Limitations Relating to Credit Rating Scales for details. Fitch Ratings also publishes other ratings, scores and opinions. For example, Fitch provides specialized ratings of servicers of residential and commercial mortgages, asset managers and funds. In each case, users should refer to the definitions of each individual scale for guidance on the dimensions of risk covered in each assessment. Fitch’s credit rating scale for issuers and issues is expressed using the categories ‘AAA’ to ‘BBB’ (investment grade) and ‘BB’ to ‘D’ (speculative grade) with an additional +/- for AA through CCC levels indicating relative differences of probability of default or recovery for issues. The terms “investment grade” and “speculative grade” are market conventions and do not imply any recommendation or endorsement of a specific security for investment purposes. Investment grade categories indicate relatively low to moderate credit risk, while ratings in the speculative categories signal either a higher level of credit risk or that a default has already occurred.

The Morningstar Medalist Rating™ is a forward-looking analysis that considers a combination of qualitative and quantitative factors. Morningstar evaluates three key pillars when assessing a fund: People, Parent, and Process, coupled with a fee assessment. Gold is the highest of five Medalist Rating categories. For the full rating methodology, click here. <For the <insert fund name> report, click here.>

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