Moody’s Ratings’ downgrade  of the credit of the United States on May 16 is not a major market moving event. Rather it is a sign along the path we are on, a path of rising sovereign debt loads and ineffective efforts either to control the growth or pay the cost of government.

The seeds of the downgrade had been in place for some time.  Moody’s is the last of the three major rating agencies to remove the triple A rating. The first, S&P Global, did so in August 2011, to the shock and chagrin of bankers and Treasury officials. This time?  A shrug by Treasury secretary Scott Bessent who said over the weekend that it was a “lagging indicator” of the condition of the United States.

Markets Monday were modestly lower, but not notably so.  Investors have cued to this path for some time and have reacted by

  • Pushing up yields on long term Treasury debt.
  • Pushing the value of the U.S. dollar lower against other currencies.
  • Raising the cost to protect sovereign U.S. debt against default.

A previous Beyond the News post described all of this.

Government ratings, whether sovereign or local, are driven by two factors: capacity to pay debt and willingness to pay.  Moody’s doesn’t question the first—the capacity of the U.S. economy to generate wealth and income.  It is the second that is in question.

There is no doubt that the fiscal imbalance of the United States has worsened in recent years or that rational discussions about what to do have been overtaken by fiscal sleight-of-hand, vague promises of future results and dire warnings of impacts.  Whether the path to fiscal balance emerges remains to be seen.

What does this mean for state and local governments?

Good news is that the downgrade does not mean Moody’s will downgrade state and local government debt that might be considered to be under that of the sovereign.  The release Friday noted that “The US’ long-term local-and foreign-currency country ceilings remain at Aaa. The Aaa local-currency ceiling reflects a small government footprint in the economy and extremely low risk of currency and balance of payment crises.”

The downgrade could result in investments that no longer comply with bond indentures, statutes or investment policies that restrict investment in government obligations to those that are in the top rating category or rated “AAA rated” by a rating agency.  This legacy language can be problematic.  After the S&P downgrade many public agencies updated their investment language to eliminate this restriction, but some relied on the continued rating of a single rating organization—Moody’s—to see them through.

Whether credit ratings should be a test in investment policies generally is a discussion for another time.  The Securities and Exchange Commission has pushed since the 2008 market meltdown to eliminate this role.  Ratings are no substitute for research and they are not infallible.  But in all events obligations of the sovereign are what they are, regardless of ratings and policies should be adjusted to recognize this.

Will this affect the credit ratings of local government investment pools?

The credit ratings of LGIPs should not be affected by the downgrade.  Virtually all of the LGIP ratings are provided by S&P or FitchRatings and these do not rely on Moody’s ratings of the underlying securities.  LGIPs and money market funds rated by Moody’s should not be adversely affected by this downgrade since what matters is the short-term or liquidity assessment of Treasury securities and the ratings downgrade des not address this.

Should Treasuries continue to be considered to be “risk-free” investments?

For entities whose spending is limited to U.S. dollars, the answer would seem to be ”yes.”  In a doomsday scenario history tells us that currency deflates, foreign investors flee and inflation rages.  None of this would be good but “risk-free” is relative and where revenue and spending is limited to a dollar-based economy short-term Treasuries would have approximately the same value as cash.

Will yields rise on account of the rating change?

History would suggest the answer is “no.”  Accompanying is a chart of the 10 Year US Treasury that was prepared by Bank of America and published in a Bloomberg commentary this morning.  The market direction for Treasuries—down in yield in 2011 when S&P acted and up in yield in 2023 when Fitch revised its rating—seems unaffected by the downgrades.

Bottom line. The recent trends toward higher long term Treasury yields, a weaker dollar and rising risk premiums to insure the credit of the United States are likely to remain until underlying circumstances change.