The US doesn't have a perfect credit rating anymore. Investors shouldn't worry yet.

Mint

18-05-2025

After the closing bell on Friday, Moody's became the last major credit-rating firm to downgrade U.S. sovereign debt from its perfect AAA status to Aa1. The firm argues that the U.S. is on a trajectory to increase entitlement spending—without the necessary government revenues to keep interest payment ratios at levels similar to other sovereign nations.
While the impact of the downgrade on bond markets won't be clear until they open Sunday night, investors may not yet have to worry about major near-term impacts to U.S. equities or Treasury yields, money managers told Barron's.
Given the U.S. hasn't had a perfect AAA rating across all major agencies for quite some time, the market has likely already absorbed some level of risk assessment, Gregory Peters, co-chief investment officer at PGIM Fixed Income, told Barron's.
Mass selling of U.S. debt by institutional investors who are required to only hold the Aaa debt is unlikely, he added. Many institutions changed their fund mandates to create a carveout for U.S. Treasuries after the U.S. received its first debt downgrade by S&P in August 2011.
'I expect the impact to be minimal," Peters said.
While some foreign investors may sell U.S. debt due to the downgrade, the implications from those sales are quite limited, and any signal that they might sell could have greater impact than any 'technical implications," he added.
The extent to which foreign investors are concerned about holding U.S. assets has been a hot topic in recent months, as the United Kingdom surpassed China at the end of March as the second-largest holder of U.S. debt (Japan remains the largest).
While data shows that foreign holdings of U.S. debt reached an all time high of $9.05 trillion in March, more recent data could reflect the period following President Donald Trump's announcement of so-called 'Liberation Day" tariffs on the world that contributed to the 10-year Treasury yield rising from 3.8% to nearly 4.6% in April. Analysts have speculated that the yield increased as foreign investors dumped U.S. debt.
However, recent Treasury auctions show net buying of U.S. debt by indirect bidders such as central banks, according to Ben Emons, chief information officer and founder of FedWatch Advisors. Weekly Japanese Ministry of Finance data also shows the country is continuing U.S. Treasury purchases.
'Irrespective of the downgrade, I think that Treasury yield volatility continues because we're in a fluctuating economic environment, and that's actually what's driving them," Emons told Barron's.
Trump's temporary walkback of 145% tariffs on China earlier this week improved the macroeconomic outlook considerably, reducing recession risk and sending equities positive on the year.
But the relief rally has also contributed to Treasury yields rising from 4.1% back to nearly 4.5% as forecasts for U.S. economic growth improved. Meanwhile, House Republicans are preparing an extension of historic Trump-era tax cuts that will increase the deficit.
'We do not believe that material multi-year reductions in mandatory spending and deficits will result from current fiscal proposals under consideration," Moody's analysts wrote in their justification for the rating downgrade.
Treasury yields are near the threshold where they have historically started exerting negative pressure on the stock market, according to Raymond James analysts and a 22V Research team led by Dennis DeBusschere.
Higher borrowing costs can increase the risk of recession when yields are around 4.7%, with the worst-performing sectors typically being communications services, real estate, consumer discretionary, financial services, the analysts said. Resilient sectors, they found, are usually utilities, materials, industrials, and energy.
If the trade war slides into the rear view mirror and public markets absorb more positive economic forecasts and manufacturing data, this downgrade is unlikely to have an impact on U.S. equities, according to Emons.
The country's large, resilient economy, the dollar's global reserve status, and the Federal Reserve's effective, independent monetary policy contributed to the agency changed its credit outlook on the U.S. from negative to stable, Moody's said.
Even if the downgrade does not impact stock or bond markets,, investors are not entirely out of the woods: Inflation data doesn't yet reflect the high tariffs that were in place in China for more than a month. Higher inflation could keep Treasury yields high as the Fed becomes wary to cut interest rates, which could also pressure U.S. equities, Emons said.
But until then, investors are pricing in an economy that's in a potential rebound.