Fitch, an independent rating agency that assesses creditworthiness, downgraded the US Long-Term Foreign-Currency Issuer Default Rating (IDR) to 'AA+' from 'AAA'.  

The rating has been cut on concerns over the state of the country's finances and mounting debt. Fitch said it had observed a "steady deterioration" in governance over the last two decades.

According to Fitch, the rating downgrade of the United States reflects the expected fiscal deterioration over the next three years, a high and growing general government debt burden, and the erosion of governance relative to 'AA' and 'AAA-rated peers over the last two decades that has manifested in repeated debt limit standoffs and last-minute resolutions.

The rating agency said that the repeated debt-limit political standoffs and last-minute resolutions have eroded confidence in fiscal management. In addition, the government lacks a medium-term fiscal framework, unlike most peers, and has a complex budgeting process. 

Rising General Government Deficits

On Tuesday, Fitch said that it expects the general government (GG) deficit to grow to 6.3% of GDP in 2023, from 3.7% in 2022, reflecting cyclically weaker federal revenues, new spending initiatives and a higher interest burden. Additionally, state and local governments are expected to run an overall deficit of 0.6% of GDP this year. The rating agency is not expecting any further substantive fiscal consolidation measures ahead of the November 2024 elections.

Fitch Forecast on Government Deficit

Fitch forecasts a GG deficit of 6.6% of GDP in 2024 and a further widening to 6.9% of GDP in 2025. The larger deficits will be driven by weak 2024 GDP growth, a higher interest burden and wider state and local government deficits of 1.2% of GDP in 2024-2025 (in line with the historical 20-year average). 

General Government Debt to Rise

Lower deficits and high nominal GDP growth reduced the debt-to-GDP ratio over the last two years from the pandemic high of 122.3% in 2020; however, at 112.9% this year it is still well above the pre-pandemic 2019 level of 100.1%. The GG debt-to-GDP ratio is projected to rise over the forecast period, reaching 118.4% by 2025. The debt ratio is over two-and-a-half times higher than the 'AAA' median of 39.3% of GDP and 'AA' median of 44.7% of GDP. Fitch's longer-term projections forecast additional debt/GDP rises, increasing the vulnerability of the U.S. fiscal position to future economic shocks.

Potential for a Recession

Tighter credit conditions, weakening business investment, and a slowdown in consumption will push the US economy into a mild recession in 4Q23 and 1Q24, according to Fitch projections. The agency sees U.S. annual real GDP growth slowing to 1.2% this year from 2.1% in 2022 and overall growth of just 0.5% in 2024. Job vacancies remain higher and the labor participation rate is still lower (by 1 pp) than pre-pandemic levels, which could negatively affect medium-term potential growth.

Fed Tightening

The Fed raised interest rates by 25bp in March, May and July 2023. Fitch expects one further hike to 5.5% to 5.75% by September. The resilience of the economy and the labor market are complicating the Fed's goal of bringing inflation towards its 2% target. While headline inflation fell to 3% in June, core PCE inflation, the Fed's key price index, remained stubbornly high at 4.1% yoy. This will likely preclude cuts in the Federal Funds Rate until March 2024. Since January, these assets on the Fed balance sheet have fallen by over $500 billion as of end-July 2023.

Implications of rate cut by Fitch:

Investors use credit ratings as a benchmark to determine how risky it is to lend money to a government. The implications of the downgrade in US rating include higher borrowing costs for the government, reduced confidence in the US economy, and increased volatility in financial markets.

This is the second time in the country’s history that its credit rating has been downgraded. The first time this happened was in 2011 when Standard & Poor’s removed the coveted AAA rating because of a prolonged struggle over the government's borrowing limit.

The three major indices traded mixed on Tuesday, where the S&P 500 fell 0.26%, at 4,576.94 points, the Nasdaq Composite dipped 0.43% at 14,284.20, while the Dow Jones Industrial Average gained 0.19% at 35,628.57 points.

The Indian rupee opened 12 paise lower at 82.38 against the US Dollar on Wednesday tracking losses in Asian currencies and reduced risk appetite after Fitch downgraded the US long-term foreign currency ratings to AA+ from AAA.