Moody's downgrade of US credit rating challenges portfolio allocations

Business Times

21-05-2025

[SINGAPORE] Moody's downgrade of the US' credit rating by a notch (Aaa to Aa1) shouldn't have come as a big surprise. Earlier downgrades by S&P in 2011 and Fitch in 2023 have raised expectations that Moody's would be next; it was only a question of when. S&P and Fitch's downgrades were prompted by concerns over US fiscal discipline – or the lack of – and the 'political brinksmanship' that took place repeatedly over the debt ceiling which made, as S&P wrote in 2011, America's 'governance and policymaking less stable, less effective, and less predictable than what we previously believed'. Fitch also noted the 'steady deterioration' in governance in fiscal and debt matters over the past 20 years.
Today, the macro backdrop differs in many respects from 2011 and 2023. The common thread, however, is the perception of continuing US profligacy at a time when it can ill afford it. While the US economy has remained remarkably resilient, Trump's tariffs have muddied the outlook for business and investment, inflation and consumer spending. The fiscal hole looks set to deepen. Trump is putting pressure on lawmakers to pass a Bill to extend tax cuts; the Bill is projected to raise the Budget deficit by US$3 trillion over the next decade.
Moody's noted in a statement that US government debt and interest payment ratios have risen to levels significantly higher than similarly rated sovereigns. It expects federal deficits to approach 9 per cent by 2035, from 6.4 per cent in 2024. 'Even though US Treasury assets remain in demand, debt affordability has deteriorated due to higher yields since 2021… While we recognise the US' significant economic and financial strengths, we believe these no longer fully counterbalance the decline in fiscal metrics,' it said.
Treasury yields have since risen, which does not bode well for borrowers. The 10-year Treasury yield this week was at 4.52 per cent and 30-year yield at 5.05 per cent. Until now, foreign investors have been willing to buy and hold US debt, but for how much longer? Portfolios heavily exposed to US Treasuries suffer a double whammy of capital loss as yields rise and the US dollar weakens. Several Asian currencies have appreciated against the US dollar. There is also a knock-on effect on equities, as higher bond yields make equities relatively less attractive.
For investors, the macro environment is raising serious questions about the role of traditional assets in portfolios. Henry McVey, KKR partner and head of global macro and asset allocation, believes markets are in the midst of a 'regime change'. In a paper in May, he argued that government bonds no longer serve as 'shock absorbers' in a portfolio. The 'Liberation Day' tariff announcement has ushered in the 'unsettling triumvirate' of US dollar weakening, equities selling off and bond prices falling – at the same time, he wrote.
'There is now an ongoing clear and present danger for global allocators who bought into the idea that when stocks sell off, bonds will always rally. Importantly, this significant breakdown in asset allocation theory is occurring not only in the US but also across most other global developed markets,' he wrote.
To be sure, investors should refrain from knee-jerk reactions, but stick to a diversified approach – across assets, geographies and currencies. This isn't easy to implement when many portfolios are overweight US assets and the dollar, and arguably need to rebalance. But inaction could be costly.