Over the weekend, Moody’s stripped the U.S. of its top credit rating.
The rating agency downgraded the U.S. from its top level of Aaa to Aa1, one notch lower. It was the first time in history that Moody’s downgraded the U.S. sovereign rating.
The move shouldn’t be too shocking for investors.
After all, S&P downgraded the U.S. back in 2011. Fitch Ratings did so in 2023.
Moody’s was the last major rating agency to remove the U.S.’s coveted triple-A rating.
But its analysis behind the downgrade is delivering a major warning on the interest rate outlook… right at a time when long-term interest rates could stage a breakout higher.
The rating downgrade, coupled with a breakout in rates, should make anyone with money in the stock market nervous…
Rising Debt Burden
Moody’s cited growing levels of government debt behind its downgrade. And the outlook for deficit spending is getting worse.
Total federal spending is projected to top $86 trillion over the next decade. During that time, the annual deficit is expected to climb from $1.7 trillion to $2.5 trillion.
That means more debt must be issued to cover the shortfall. A larger pile of debt also means higher interest payments.
Relative to the size of the economy, the U.S. can expect to spend almost twice as much servicing its debt compared to the next highest developed economy.
The chart below shows the size of interest payments on government debt relative to gross domestic product (GDP).
The U.S. will end up spending 4.6% of its GDP on interest payments. Greece is the next closest at 2.5%. The average for developed nations is 1.3%.
That means the U.S. is already spending over three times the average… just this year.
But federal debt levels will keep increasing in the years ahead as the government spends more money than it collects.
The current federal debt-to-GDP ratio sits right at 100%. Projections show it increasing to 118% by 2035.
And all this could push interest rates higher. That poses a risk to the economy as well as investor portfolios.
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Watch for a Breakout in Rates
Analysts have been sounding the alarm on rising government debt levels for nearly as long as I can remember. Yet some may have grown deaf to the claxon sound.
After all, it has been nearly 14 years since S&P downgraded the U.S. credit rating, and there hasn’t been a debt crisis.
But that could soon change. Interest rate levels are the key factor.
Longer-term interest rates are close to breaking out. Take a look at the chart of the 30-year Treasury yield:
The 30-year yield has tested the 5% level on several occasions going back to 2023 (see the box).
A breakout in the 30-year rate above 5% could signal that investors are becoming more concerned about deficit spending and debt levels. They’re demanding higher interest rates to lend to the government. Demanding more compensation to lend reflects the increasing risk of default.
The last time the 30-year was above 5% happened in 2007. Back then, the debt-to-GDP ratio stood at 35%, compared to 100% now.
New borrowings and the refinancing of existing debt at higher levels could create a negative feedback loop and push rates higher still. (Continued deficits mean the government is issuing more debt… now at a higher interest rate. And when existing debt matures, it might have to be refinanced at higher rates.)
Higher interest rates can also negatively impact the economy due to higher borrowing costs for consumers and corporations alike. That can crimp household spending and corporate earnings.
And it pressures stock market valuations. A jump in 30-year yields was a major factor behind 2022’s bear market.
That’s why investors need to keep their attention fixed on interest rates despite the recent calm in the stock market.
Moody’s may have been the last to downgrade the U.S. credit rating… but it might have got the timing right.
Happy Trading,
Larry Benedict
Editor, Trading With Larry Benedict
P.S. If you want to hear me talk more about rates and more, be sure to tune in to tradingwithlarry.com at 8:30 a.m. ET from Monday through Thursday.
You can find yesterday’s podcast here on YouTube.
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