VTI - Should S&P Now Upgrade U.S. Debt To AAA?

2023-06-02 11:15:27 ET

Summary

• The U.S. Congress has passed a bill to suspend the debt ceiling until January 2025, averting a default on U.S. debt.
• S&P downgraded U.S. debt to AA+ in 2011 due to concerns about political divisions and fiscal policy, and it is unlikely to upgrade it to AAA despite the recent bipartisan agreement.
• The U.S. debt rating will continue to be influenced by political outcomes and the persistence of a moderate bipartisan group in Congress, with the debt ceiling debate set to return in 2025.

The U.S. Congress passed the bill that averts the U.S. default and suspended the debt ceiling until January 2025. The U.S. debt technically continues to be risk-free. Should Standard & Poor rating agency now upgrade US debt to AAA?

S&P Downgraded US Debt to AA+ in 2011

On August 5, 2011, S&P downgraded U.S. sovereign debt, lowering the rating from "AAA" to "AA+", with a negative outlook, citing the issue with the "g overnance and policy-making stability" related to the 2011 U.S. debt-ceiling crisis . This is the S&P post downgrade statement (emphasis added):

More broadly, the downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges to a degree more than we envisioned when we assigned a negative outlook to the rating on April 18, 2011. Since then, we have changed our view of the difficulties in bridging the gulf between the political parties over fiscal policy, which makes us pessimistic about the capacity of Congress and the Administration to be able to leverage their agreement this week into a broader fiscal consolidation plan that stabilizes the government's debt dynamics any time soon.

The political brinksmanship of recent months highlights what we see as America's governance and policymaking becoming less stable, less effective, and less predictable than what we previously believed. The statutory debt ceiling and the threat of default have become political bargaining chips in the debate over fiscal policy . Despite this year's wide-ranging debate, in our view, the differences between political parties have proven to be extraordinarily difficult to bridge , and, as we see it, the resulting agreement fell well short of the comprehensive fiscal consolidation program that some proponents had envisaged until quite recently. Republicans and Democrats have only been able to agree to relatively modest savings on discretionary spending while delegating to the Select Committee decisions on more comprehensive measures. It appears that for now, new revenues have dropped down on the menu of policy options . In addition, the plan envisions only minor policy changes on Medicare and little change in other entitlements, the containment of which we and most other independent observers regard as key to long-term fiscal sustainability.

Note, S&P downgraded U.S. debt after the 2011 debt ceiling deal, primarily viewing the deal as insufficient in stabilizing longer term U.S. debt stability. Specifically, S&P viewed the spending cuts as "modest" and tax increases as nonexistent. Further, S&P viewed the U.S. political divide as the potential barrier in future debt ceiling negotiations.

In other words, S&P suggested that the U.S. deficits will continue to growth, the U.S. debt will continue to rise absolutely and as the percentage of GDP, and eventually the politicians could fail to agree on suspending the debt ceiling - which would result in a default.

Fast forward to the 2023 debt-ceiling event

John Chambers, who was the deputy head of the Sovereign Debt Ratings Group and chairman of the Sovereign Debt Committee at Standard and Poor's, was heavily criticized and blamed for being responsible for downgrading U.S. debt.

He appeared on CNBC on May 30th, 2023, to discuss the 2023 debt ceiling debate and the 2011 U.S. debt downgrade. He apparently felt vindicated by his heavily criticized U.S. debt downgrade in 2011. The U.S. debt / GDP increased from 94% in 2011 to nearly 130%, and the political divide only increased. He was very pessimistic that the eventual 2023 deal would fall short on spending cuts and tax increases, essentially sticking to his 2011 outlook.

Note, S&P still holds the AA+ rating on U.S. debt. Here is the table with the history of U.S. debt rating from all major agencies.

More US debt downgrades coming after the 2023 deal?

As the Table above shows, Fitch, has already placed U.S. debt on rating watch negative :

The Rating Watch Negative reflects increased political partisanship that is hindering reaching a resolution to raise or suspend the debt limit despite the fast-approaching x date.

Note, on April 18, 2011, S&P also issued a "negative" outlook on the U.S.'s AAA sovereign-debt rating indicating there was a "one-in-three chance of an outright reduction in the rating over the next two years," and stated:

We believe there is a material risk that U.S. policymakers might not reach an agreement on how to address medium– and long-term budgetary challenges by 2013; if an agreement is not reached and meaningful implementation is not begun by then, this would, in our view, render the U.S. fiscal profile meaningfully weaker than that of peer 'AAA' sovereigns.

What's the difference between the 2011 and 2023 "negative outlook" on U.S. debt? S&P pointed to "medium and long term challenges" in 2011, while Fitch is specifically addressing the probability of the 2023 default.

Thus, it is unlikely that Fitch would downgrade U.S. debt, given that the debt-ceiling deal passed the U.S Congress with a wide bipartisan centrist majority.

Should S&P now upgrade U.S. debt?

However, at the same time, S&P is unlikely to upgrade U.S. debt rating to AAA, given the Chamber's comments as discussed before.

On positive side, we learned during the 2023 debt ceiling debate that there is a very wide centrist moderate bipartisan group in the House of Representatives and the Senate, while the influence of the more conservative group on the right, and the progressive group on the left is insignificant. This is a very positive development that invalidates some of the Chamber's predictions.

However, these apparent "centrists" possibly just wanted to avoid the U.S. default at all costs - due to the related catastrophic market consequences. The fact is that $4 trillion of additional US debt will push the U.S. debt/GDP ratio towards 135%.

What happens in 2025 when the debt ceiling needs to be raised again? Obviously, the approval for more debt with the debt/GDP ratio going towards 140% will become more difficult to implement. Further the centrist group could fraction as the debt sustainability reality trumps the fear of default.

So, what happens in 2025? The left could draw the line at raising the taxes. The right could draw the line at significant cut in spending. But both of these will be necessary, and thus, impossible to pass.

The U.S. will have to: 1) significantly decrease spending; and 2) significantly increase taxes. That's what S&P has been saying since 2011, and they will likely stick to their call.

Implications

Investors in U.S. Treasuries ( TLT , SHY ) will be facing the debt ceiling event again in 2025. At that point, it is likely that the U.S. debt will be between 130% and 135% of the GDP.

The U.S. Debt rating obviously depends on the outcome of the 2024 election. If one party sweeps the control of the Congress and the Presidency, the debt ceiling suspension in 2025 will be a technicality. However, if the legislative control is split one way or the other, the 2025 debt ceiling debate will likely be heavily contested. More specifically, the U.S. debt rating depends on whether the moderate bi-partisan group in the U.S. Congress persists.

Thus, the U.S. debt cannot be considered as risk-free as long as there is a statutory debt ceiling, and the Congress has the authority to increase the debt ceiling.

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