Credit downgrade to a downhill slide?

Signs keep pointing to capital betting against the U.S.

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On May 16, Moody’s became the last of the big three ratings agencies to downgrade U.S. sovereign debt below a AAA rating. Beginning with S&P in 2011 and followed by Fitch in 2023, credit analysts have continually dimmed their views of the world’s most powerful state and its ability to repay its debts.

This move might seem technical, and for the informed it reads as merely symbolic -- the United States government prints the money it needs to pay its debts, so default should be impossible. In the context of other recent financial news, however, Moody’s reassessment represents an important signal that the global economy is undergoing an historic shift unprecedented in at least 50 years.

Their bet, and ours: the future isn't very bright for the dollar or the system that made it valuable.

Moody’s downgraded U.S. credit for different reasons than S&P and Fitch. The two previous drops from AAA ratings came amidst congressional brinksmanship over the debt ceiling -- Republicans threatened both times to allow the Treasury to default as a pressure tactic on Democratic presidents Barack Obama in 2011 and Joseph Biden in 2023.

But the Moody’s downgrade has nothing to do with what Congress is refusing to do, and everything to do with what they are on the verge of accomplishing. Namely, lawmakers will soon add at least $3 trillion to the federal budget deficit despite GOP control of the White House and both houses of Congress. This means taking the deficit from 6% of GDP annually to 7% or more -- a level that would make any other country’s debt junk.

Unlike any of those other countries, however, the United States has extraordinary demand for its sovereign debt as the dollar makes up 57.8% of global currency reserves, a necessary stockpile for governments and businesses everywhere as 54% of global trade is settled in greenbacks. Legislators and presidents from both parties have taken advantage of this privilege by spending exorbitantly on a globe-bestriding military, healthcare and pensions for middle class retirees with high voter turnout, and a variety of subsidies for politically-connected industries. All the while, Republicans have repeatedly cut taxes on high incomes, capital gains, and corporate earnings -- cuts that Democrats have tended to preserve when they take their turn in office.

As long as investors could justify the spending as boosting economic output, and as long as the tax cuts seemed to drive real investment and business activity, they could ignore the deficit. In fact, by generating so much high quality capital in the form of Treasury bonds, it helped recycle U.S. dollars and kept the dollar at the center of the global economy. The deficit boogeyman only needed to be trotted out when someone suggested things like universal healthcare or free college education; nobody took it seriously.

Moody’s downgrade suggests that the analysts trusted by these investors to assess long-term risks have shifted their view. More importantly, they seem to already be voting with their dollars, as interest rates on long-term debt have increased significantly this year: yields on 30-year Treasury bonds are up about 50 basis points since the start of the year, briefly breaching 5% in April.

Rates go up when prices go down, and prices go down when demand drops off. Capital doesn’t see long-term U.S. debt as a safe investment, so they are demanding higher interest payments to take the risk of buying these bonds.

What risk do they perceive? Again, the risk of default is virtually nil, but so too is the likelihood that the United States will pay off its debt through earnings generated by real economic activity. The debt load is simply too great for normal growth to cover it. Instead, the Treasury will likely monetize the debt through one mechanism or another, printing money to pay it off, inflating its way out of the hole.

Enter now the new era of Donald Trump’s protectionism, a blow to any residual dollar demand that might have washed away these deficit sins. The administration has put eliminating the country’s trade deficit -- as opposed to its budget deficit -- at the center of its policy, i.e. buying fewer goods and services from other countries, reducing the overall supply of dollars worldwide. Those countries will soon find financing their trade more expensive -- as dollars grow more scarce -- unless they reduce demand for dollars by moving to other means of settling their transactions with other countries.

Large investors are already showing fears of a rotation away from the dollar order with gold surging 25% since January, crossing the $3,500 per ounce threshold briefly in April. Since the end of World War II the dollar has been “as good as gold” -- officially until 1971, and de facto in the decades since. Now that bedrock is starting to crumble, driving capital back into the real thing while trembles shudder across the world economy.

We will see where this trend ends up, but two areas to watch:

First, how will internal U.S. policy shift as this nascent fiscal crisis deepens? In 2022 the United Kingdom experienced the same loss of First World economic status when bond markets melted down over a tax cut package proposed by then-Prime Minister Liz Truss. Since then, both Tory and Labour governments have pursued aggressive austerity policies with a parallel collapse in quality of life across the country.

Activists and organizers in the United States should prepare to resist major cuts to core social spending programs well beyond anything currently suggested even in the stingiest GOP budget proposals.

Second, how will the global economy move away from the dollar? For decades economic observers have waved away fears of dollar decline on the basis that no other currency seemed to offer an alternative as the basis for global trade. The most likely path forward, however, might not be a rotation into another global currency regime, but rather the return of a commodity-based economic order. For large financial reserves this might mean gold, but more importantly for commerce it would mean bilateral agreements between producing countries to trade in their respective currencies, exactly the sort of deals China has accelerated in the last decade.

Bilateral payment agreements have the value of the commodities and services being exchanged as their basis -- these currencies are backed by the productive capacities of their respective economies. China agrees to be paid in reales because they calculate that Brazil will be producing goods that they will want to buy in the future. Brazil accepts yuan for the same reason. This implies an economy led not by bankers playing tricks with balance sheets, but by industries producing real output to satisfy development needs.

For all his talk about bringing such production back to the United States, Donald Trump has yet to propose any real industrial policy that could generate the investment needed to bring back manufacturing outsourced decades ago to the countries now positioned to reshape the world’s financial system on their terms.

Markets might not have done all the math yet, but they know enough to bet against good news for the U.S. economy in the long run. Moody’s is just telling it like these shareholders see it.

Disclaimer

Our only investment advice: Long Halliburton.