August 8, 2023
By Gerald B. Goldberg, JD, CIMA®, CEO, and Co-Founder
On August 1st, Fitch (one of the Big Three credit ratings agencies) announced that it was downgrading its assessment of the credit quality of U.S. debt.[1] In Fitch’s view, Treasuries are no longer AAA. Instead, they have been assigned a rating of AA+, the second highest rating possible. This is the second time a major ratings agency has downgraded the U.S. after S&P did so in 2011, meaning two of the Big Three now rate the U.S. as AA+.
Reactions to the announcement were divided. While some commentators interpreted the downgrade as the beginning of the end of dollar dominance, most investors seemed unfazed. Larry Summers, a former Treasury Secretary, admitted that the U.S. faces fiscal challenges, but called the downgrade “bizarre and inept.”[2]
In truth, neither reaction is entirely justified. Brushing Fitch’s downgrade off as unimportant or misinformed ignores the profound challenges facing the United States (and the dollar) both domestically and globally. Moreover, such a casual reaction minimizes the extraordinary privilege and responsibility the U.S. has in managing the world’s dominant reserve currency.
But believing this is a watershed moment that heralds the end of the dollar is also naïve. The dollar continues to be the currency of choice for international trade, and Treasuries are still seen as the safest dollar-denominated investment. Markets largely shrugged off the announcement; stocks fell slightly, but Treasury yields were basically unchanged. Not what we would expect to see if Fitch’s downgrade marked the start of a new global order.
In this edition of Gerry’s Journal, we will outline why Fitch’s announcement changes very little in the near term, but highlights some of the long-term challenges facing the dollar. We will also explore how the evolving situation could impact the capital markets and investment portfolios. To introduce these issues, we will start by looking at why exactly Fitch chose to downgrade the U.S.
If you have been monitoring the financial position of the U.S. over the past few years, very little in Fitch’s announcement should surprise you. The agency noted that political issues have led to a deterioration in fiscal governance, manifesting most prominently in repeated last-minute resolutions to debt ceiling crises.
These issues have also led to slow progress in tackling larger fiscal challenges related to federal programs such as Social Security and Medicare.
Rising government deficits, which must be financed with additional borrowing, also contributed to the downgrade. Fitch expects the overall government deficit to rise from 3.7% last year to 6.3% this year. Meanwhile, America’s debt-to-GDP ratio is significantly higher than it was pre-pandemic. Q1 2023 debt stood at about 118% of GDP, compared to just over 106% in Q4 2019.[3]
Higher interest rates have coincided with this higher debt burden to increase the cost of servicing such an extraordinary amount of debt. Servicing the cost of debt might be easy to handle when interest rates are hovering around 0% – less so when the 3-month Treasury yield has surpassed 5%.
Finally, Fitch noted that they expected the U.S. to fall into a recession at the end of the year. We believe this projection is far from certain, as the economy has shown resilience that could result in a soft landing. However, there is a risk that a weak business environment and economic contraction could stretch government finances further.
Clearly, Fitch’s concerns mostly relate to domestic issues. While these are all real challenges, we are optimistic that they are eminently solvable. Rising political partisanship will make negotiating agreements more difficult, but by no means impossible. In fact, it is in the international arena, which Fitch pays less attention to, that the threat to U.S. debt is most salient.
America is unique in the fact that its domestic currency is also the world’s currency, as the dollar is the preeminent global “reserve.” In practical terms, this means that when two countries trade with each other, they typically use dollars to do so. The net effect is that most countries have a disproportionate stock of dollars saved up compared with nearly every other currency – dollars make up about 60% of central bank FX reserves worldwide, about three times more than the next most popular currency.[4]
Of course, all these dollars must go somewhere. And at this scale, the answer is not as simple as opening a bank account. Instead, these dollars are used to buy the safest and most liquid dollar asset possible – Treasuries. This dynamic creates tremendous demand for Treasuries, meaning the U.S. has traditionally been able to issue far more debt than it might otherwise be able to. It is for this reason that the former French President Valery Giscard d’Estaing called America’s privilège exorbitant.
As such, the U.S. has been able to sustainably finance large government deficits at relatively low interest rates. Crucially, though, such stability is centered on the dollar continuing to be the global reserve currency. If the world abandoned the dollar, demand for Treasuries would plummet, leading to higher interest rates and an inability for the U.S. to continue to finance its deficits.
This connection means the prospects of the dollar and Treasuries are inextricably linked. If Treasuries are deemed too risky (say, due to a downgrade from a major credit agency), they might be sold off by global central banks and reallocated to another currency. This could make it far more difficult for the U.S. to finance deficits. Moreover, the U.S. has used control of the dollar to further foreign policy objectives, such as by cutting Russia off from the SWIFT international payments system due to its invasion of Ukraine. Were the dollar to lose its reserve status, the U.S. would be unable to use it to project power globally, nor would the U.S. be able to sustain the current level of spending.[5]
While the Fitch downgrade is not the harbinger of change that some dollar pessimists claim, it is another piece of evidence for the threats facing the dollar on the horizon. Since we live in an increasingly multipolar world where the U.S. is not the only global hegemon, many countries have been trying to develop their own reserve currency alternatives. Examples of efforts undertaken by other countries to develop alternatives to SWIFT include Russia’s creation of the System for Transfer of Financial Messages (SPFS) and China’s establishment of the Cross-Border Interbank Payment System (CIPS). While the U.S. Dollar and the SWIFT system are not at risk of disappearing tomorrow, the Renminbi’s (China’s unit of currency) share of trade finance has grown from less than 2% in February 2022 to 4.5% today.[6]
Beyond the creation of alternative payment systems, several countries that are resentful of the U.S. dollar’s dominance are actively working on central bank digital currencies networks (CBDCs). While this effort is still in its relative infancy, in December 2022, the number of countries that are working on developing a CBDC had grown to 114, with 11 countries having already launched a digital currency.[7]
As the leader of the free world, the U.S. has not shied away from using the dollar as a tool to protect both its own interests and those of close allies. Unsurprisingly, this has made countries who do not share the American worldview increasingly uncomfortable using dollars to trade.
In particular, many oil-exporting countries are looking for alternatives to the traditional “petrodollar” trade, wherein oil is denominated and sold in dollars. For instance, Russia has recently sold oil to India for both Renminbi and rupees.[8] Earlier this year, Brazil and China also agreed to drop the dollar for their bilateral trade.[9]
In the context of the enormous scale of global trade, these agreements are relatively small. They do represent, though, that the world is a far different place than it was even a decade ago. America is not the sole global power anymore, with landmark peace agreements being brokered by countries like China.[10] This means that the dollar’s status cannot be taken for granted and must be responsibly managed by policymakers.
With that being said, any significant decline in dollar dominance will take place over a long-time horizon. Sheer inertia ensures that, while there are certainly challenges to tackle in the intermediate term, we are very unlikely to see significant changes in the status of either the dollar or Treasuries in the short term. Despite the prognostications of certain TV talking heads, the impact on investors is likely to be relatively muted.
As we have outlined, the Fitch downgrade certainly underlines that the U.S. faces both domestic and international challenges in terms of managing its debt. But the indifferent market reaction highlights that the announcement did not contain much new information. In the short term, the world is not going to stop using dollars, and investors are unlikely to see any significant portfolio impact.
In the long term, though, the episode highlights the importance of having a well-diversified portfolio of assets that also includes exposure to non-dollar investments. This country has been, and will continue to be, a wonderful place to invest, driven by American ingenuity and our capacity to draw the brightest minds from around the world. But the environment has certainly changed over the past several decades, and balancing our risk exposure with thoughtful international allocations will be important over the next several decades.
Our constructive vantage point is bolstered by the few apparent lasting impacts from the past downgrade of American debt, by S&P in 2011.[11] Since that time, the country has overcome significant challenges and the stock market has continued to march higher. Finally, recent economic data continues to look strong, with real consumer spending increasing and GDP expanding.[12], [13]
Certainly, the issues we discussed today will continue to evolve over the next several years. Through that time, our team will be here to guide you and your family on your wealth journey. If you would like to speak about any of the topics covered in this edition of Gerry’s Journal, or any aspects of your financial plan, we invite you to connect with our team.
The views contained in this document represent the opinions of GYL Financial Synergies, LLC as of the date hereof unless otherwise indicated. This and/or the accompanying information was prepared by or obtained from sources GYL Financial Synergies, LLC believes to be reliable but does not guarantee its accuracy. This document contains forward-looking statements, predictions, and forecasts (“forward-looking statements”) concerning our beliefs and opinions in respect of the future. Forward-looking statements necessarily involve risks and uncertainties, and undue reliance should not be placed on them. There can be no assurance that forward-looking statements will prove to be accurate, and actual results and future events could differ materially from those anticipated in such statements. The report herein is not a complete analysis of every material fact in respect to any security, mutual fund, company, industry, or market sector. The material has been prepared or is distributed solely for information purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Past performance does not guarantee future results. CAR20230808GJAUG
[1] Fitch Ratings, Fitch Downgrades the United States’ Long-Term Ratings to ‘AA+’ from ‘AAA’; Outlook Stable Link
[2] X, Lawrence H. Summers @LHSummers Link
[3] St. Louis Fed Economic Data, Federal Debt: Total Public Debt as Percent of Gross Domestic Product Link
[4] International Monetary Fund, Currency Composition of Official Foreign Exchange Reserves Link
[5] Reuters, Explainer: What is SWIFT and how will its removals impact Russia? Link
[6] Financial Times, Renminbi’s share of trade finance doubles since start of Ukraine war Link
[7] Reuters, IMF working on global central bank digital currency platform Link
[8] Reuters, Indian refiners used yuan to pay for some Russian oil imports, official says Link
[9] Barron’s, China, Brazil Strike Deal To Ditch Dollar For Trade Link
[10] Barron’s, China Surges Ahead in Middle East Diplomacy Link
[11] New York Times, S.& P. Downgrades Debt Rating of U.S. for the First Time Link
[12] St. Louis Fed Economic Data, Real Personal Consumption Expenditures Link
[13] St. Louis Fed Economic Data, Real Gross Domestic Product Link