A week of continued volatility in financial markets and rising political stress in Congress came to a turbulent end when the ratings firm Moody’s downgraded the credit rating of U.S. debt from the highest level at AAA to one notch below, at Aa1.
Yields could very well rise in the near term with the 30-year Treasury note testing 5% and the 10-year approaching 4.5%.
In announcing the downgrade, Moody’s cited concerns over the federal budget deficit, which it expects to increase to nearly 9% from 6.4% last year. Moody’s joined two other agencies that in past years have lowered the U.S. credit rating.
The move followed a week of continued stress in financial markets as the yield on 10-year Treasury bonds traded as high as 4.55% despite market expectations of a more accommodative monetary policy.
Investors were responding to rising perceptions of risk in the American economy, including the prospect of tariff-induced inflation and runaway budget deficits.
Now, with the downgrade, yields could very well rise in the near term with the 30-year Treasury note testing 5% and the 10-year approaching 4.5% as investors ascertain the risk of holding long-term government debt.
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In a reflection of the rising perceptions of risk, the U.S. term premium has increased by approximately 108 basis points this year as investors bid up the compensation required to hold such debt.
The U.S. is running federal budget deficits of roughly $2 trillion per year as rising interest rates push up the cost of servicing government debt.
Years of dysfunction, debt ceiling stand-offs and fiscal imprudence have brought the U.S. to this outcome.
It’s critical that the public understand that anything financed in both the public and private sector will now be more expensive. This is a day that did not have to happen.
In an emerging market economy, a period of fiscal consolidation would normally follow the downgrade of a country’s credit rating.
Instead, in the U.S., lawmakers will most likely approve another large unfunded tax cut followed by further loss of confidence and credibility in the dollar and dollar-denominated assets.
The Yale Budget Lab estimates that current proposed legislation would add $3.4 trillion to the federal debt from 2025 to 2035 and $13.5 trillion from 2025 to 2055.
State of play
The bond market began anticipating additional cuts in the federal funds rate at the end of last year, expecting further normalization of interest rates at the front end of the yield curve, But bond investors have also been pricing in the increased risk of holding a 10-year Treasury bond to its maturity.
This so-called term premium component of the 10-year Treasury turned positive last November and is now adding about 75 basis points onto the yield on 10-year Treasury bonds.
This development can be attributed to the risk of higher inflation that would reduce the real, or inflation-adjusted, earnings of Treasury bonds.
There are other factors to consider as well. There is the volatility premium, sending yields higher because of the increased prices caused by tariffs. And there is the uncertainty regarding the dollar, sending some foreign holders of U.S. debt scrambling for the safety of cash at home.
Finally, there is the ongoing debate over the U.S. fiscal stance. We are long past the budget surpluses of the late 1990s that lasted into 2001. Now, the only question is how much debt will be incurred to fund the coming tax cuts.
With growth overseas likely to suffer because of the tariffs, there is the prospect of a worsening goods deficit and a widening current account deficit if foreign investors grow anxious over holding U.S debt.
The front end of the yield curve suggests market expectations of the Federal Reserve responding to slower growth with rate cuts over the next two years.
Yield increases at the long end of the curve suggest a market anticipating greater risk of default on newly written mortgages.
For now, we anticipate the 10-year trading with a center of gravity of 4.5%.
