What The US Credit Rating Downgrade Means For Investors
US debt rating has been downgraded from AAA to AA+
Last updated: August 3, 2023
Author: Nathan Nobert
A ripple has been sent through various stock markets as the US debt rating has been downgraded from AAA to AA+ as news came out on August 2nd, 2023. A “steady deterioration in standards of governance” has been cited by Fitch, a large American credit rating agency. News like this can impact markets, and the economy, and investor sentiment.
Key Takeaways
- - Increased Borrowing Costs – Could debt be more expensive for US to acquire?
- - Stock Market Volatility – Uncertainty can lead to market swings
- - Currency Depreciation – The overall strength of the dollar may be impacted
- - Inflation & Interest Rates – Could inflation stay high, as interest rates may not drop as fast?
- - Long-term Economic Impact – Fad, or long term?
When a country's credit rating is downgraded, it means that rating agencies believe there's an increased risk that the country may not be able to pay back its debt. This can happen for various reasons, such as political instability, economic downturn, or increased national debt.
When analyzing the last couple years and decades of the US economy, many events could have lead credit agencies to be hesitant about the US’ ability to maintain such high standards with their debt.
Increased Borrowing Costs
When a country's credit rating is downgraded, it's essentially a signal to investors and lenders that the risk of lending to that country has increased. While an AA+ compared to an AAA is a very slight difference, when dealing with massive scales of debt on a country level even a small increase in borrowing can accelerate the amount of debt.
For the United States, a downgrade in its credit rating could mean that it will have to pay more interest on its new debt issues. This is significant because the U.S. government is one of the world's largest borrowers. The US debt ceiling has constantly been increased due to increasing needs for more capital to run a large economy.
But the impact doesn't stop at the government level. These increased borrowing costs can trickle down to consumers and businesses. As the government pays higher interest rates, it sets a trend for the rest of the economy. Banks and financial institutions may increase their interest rates for loans and mortgages. This means that businesses could face higher costs when they borrow money to expand or manage their operations.
Stock Market Volatility
A credit rating downgrade can introduce a significant amount of uncertainty into the financial markets. This uncertainty stems from concerns about the country's economic stability and its ability to meet its financial obligations. When investors are uncertain, they often react by selling off assets, which can lead to increased volatility in the stock market.
We’ve already seen the market react negatively to this news, as expected. The DOW is down about 2%, S&P down about 1.4%, and the NASDAQ also down over 1%. This isn’t a huge downturn, but it is keeping markets dormant and will hurt immediate price sentiment.
Volatility isn’t bad for all investors, this could be a great opportunity to buy the dip or look for companies that may have had more drastic price moves. If you are a long term investor, this news likely won’t play a factor in your strategy as this news will blow over.
Different market sectors will react differently to this news. Healthcare companies seemed to fair well with this news, while the technology sector faced a very large sell-off with some companies like AMD dropping by over 7% today. Use market sector knowledge, combined with news to your advantage when selecting stocks.
Currency Depreciation
A country's credit rating is a measure of its creditworthiness, or its ability to repay its debts. When a country's credit rating is downgraded, it suggests to investors that the country's economic stability is at risk. This can lead to a decrease in demand for that country's currency on the foreign exchange market, which can result in currency depreciation.
The US dollar has typically been seen as a strong currency, with news like this there could be impacts to its credibility. Foreign markets, imports and exports could be affected by changes to a currencies power.
Currency depreciation can have significant economic implications. One of the most immediate effects is that it makes imports more expensive. This is because it takes more of the depreciated currency to buy the same amount of foreign goods. For a country like the United States, which imports a large amount of goods, this could lead to increased costs for businesses and consumers alike.
Inflation & Interest Rates
Inflation is the rate at which the general level of prices for goods and services is rising. When inflation is high, the purchasing power of the currency decreases. Central banks, like the Federal Reserve in the U.S., often aim to keep inflation within a target range, typically around 2%. They do this by adjusting interest rates.
Interest rates are a key tool used by the Federal Reserve to control inflation. When inflation is high, the Fed can raise interest rates to cool down the economy. Higher interest rates make borrowing more expensive, which can reduce spending by both consumers and businesses, slowing economic activity and, in turn, inflation.
So, in this situation, we have two opposing forces at work. On one hand, higher interest rates could put downward pressure on inflation. On the other hand, a weaker dollar could put upward pressure on inflation. The net effect on inflation would depend on the relative strength of these two forces.
The U.S. credit rating downgrade could lead to a complex relationship between inflation and interest rates. The ultimate impact on inflation would depend on a variety of factors, including the response of policymakers, the reaction of the markets, and broader economic conditions.
Long-Term Economic Impact
A credit rating downgrade, such as the one experienced by the United States, is not too common of an event. Its effects can be far-reaching and long-lasting, influencing the economy in several ways. As we've discussed, a downgrade can lead to increased borrowing costs, stock market volatility, currency depreciation, and fluctuations in inflation and interest rates. These effects can have both immediate and long-term impacts on the economy.
It's important to note that a credit rating downgrade is not an economic death sentence. Countries, including the United States, can bounce back from a downgrade. Policymakers can implement strategies to stabilize the economy and restore confidence among investors. This could involve fiscal measures to manage the country's debt levels, monetary policies to control inflation, or structural reforms to promote economic growth.
In conclusion, while a U.S. credit rating downgrade can have significant short-term impacts, its long-term effects are not set in stone. The ultimate impact on the economy will depend on a multitude of factors, including the actions taken by policymakers in response to the downgrade. As investors, it's crucial to stay informed and understand these dynamics as they can influence investment decisions. But remember, investing is a long-term game, and temporary economic events, while important, are just one piece of the puzzle.
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