Preface
Recently, Moody's became the last of the three major rating agencies to kick the United States out of the "AAA club". The downgrade did not surprise the market. What is more intriguing is that while Moody's downgraded the rating, it also turned its outlook to neutral. On the one hand, sovereign credit is downgraded, while on the other hand, the risk outlook has stabilized. What signal is hidden behind this? The question is: How can this beautiful country, with its off-the-charts fiscal deficit, daily political quarrels, and almost annual government shutdowns, still give rating agencies a glimmer of hope?
Now that the dust has settled on the ratings downgrade, has the market become numb to the US debt warning?
On May 16, 2025, Moody's rating agency downgraded the U.S. sovereign credit rating from the highest level Aaa to Aa1 and adjusted the outlook from negative to stable. This move officially caused the United States to lose its last Aaa rating, meaning that the three major rating agencies, Standard & Poor's, Fitch and Moody's, no longer list the United States as the country with the highest credit rating. It also reflects the deep-seated financial challenges facing the United States. The core reason for the downgrade is that the U.S. government debt and interest payment ratio has continued to rise over the past decade to a level significantly higher than that of sovereign countries with similar ratings, and successive governments and Congress have failed to reach effective measures to reverse the trend of large annual fiscal deficits and growing interest costs. But overall, the marginal impact of the rating adjustment is decreasing, not only because it is not the first time the rating has been downgraded (as early as August 2011, Standard & Poor's downgraded the US rating from Aaa to Aa1, and Fitch made the same adjustment in August 2023), but also because Moody's downgrade of the credit rating did not give any views that the market has not yet discovered, and the negative impact on the market seems to be limited in the short term.
The following content is an analysis based on Moody's downgrade of the US rating. The original text can be read at: https://static.poder360.com.br/2025/05/comunicado-moodys-nota-eua-16mai2025.pdf
Key factors for the downgrade
The sharp increase in debt burden:
The U.S. federal debt has risen sharply over the past decade due to persistent fiscal deficits, a trend that became the main driver of Moody's downgrade. According to the latest forecast from the Congressional Budget Office, the federal budget deficit will reach $1.9 trillion in 2025, or about 6.2% of GDP, and by 2035, the adjusted deficit will grow to $2.7 trillion, or 6.1% of GDP. This figure is far higher than the average deficit level of 3.8% over the past 50 years, showing a serious deterioration in the US fiscal situation.
Federal debt as a percentage of GDP is expected to rise from 100% in 2025 to 118% in 2035, surpassing the all-time high of 106% set in 1946. Moody's predicts that if the provisions of the 2017 Tax and Jobs Act (TCJA) are extended, the federal debt burden could rise to around 134% of GDP over the next decade and 98% in 2024. This debt trajectory reflects the structural fiscal challenges facing the United States. On the other hand, mandatory spending in the United States will significantly compress fiscal space. It is expected that such spending will account for 78% of total government spending in 2035, up from 73% in 2024, further weakening fiscal flexibility.
The sharp rise in interest burden:
The surge in interest costs was another key factor in Moody's downgrade. Since 2020, U.S. net interest payments have nearly doubled from $345 billion to $882 billion in 2024. Moody's predicts that interest payments will account for 30% of government revenue by 2035, far higher than 18% in 2024 and 9% in 2021, which means that the sustainability of debt financing is deteriorating.
Figure 1: U.S. net interest costs over the past 10 years (Source: Department of the Treasury)
In addition, Moody's pointed out that even though global funds still have a high demand for U.S. Treasuries, the upward trend in yields since 2021 has significantly affected debt affordability. In 2024, interest payments to the U.S. general government (covering federal, state, and local governments) will account for 12% of revenue, far higher than the 1.6% average for countries with similar Aaa ratings. There are currently 11 countries with Moody's highest ratings, namely: Australia, Canada, Denmark, Germany, Luxembourg, the Netherlands, New Zealand, Norway, Singapore, Sweden and Switzerland. In short, the proportion of U.S. government debt and interest expenditure has continued to rise over the past decade, and the level is already significantly higher than other sovereign countries with the same rating, which is the main reason for this downgrade.
From negative to stable: structural advantages still exist
Although Moody's downgraded the US sovereign credit rating from the highest level Aaa to Aa1, it also adjusted the outlook from negative to stable. What kind of operation is this? It's like a teacher who gives you a low grade but pats you on the shoulder and says, "Not bad, you have great potential." The implication seems to be telling the market, "Although there is considerable short-term fiscal pressure, the overall health of the United States is still strong."
Why does Moody's make such a judgment? Their view is based primarily on several long-term structural advantages:
First, the U.S. economy is large enough and resilient enough. In 2024, the per capita GDP of the United States will reach US$85,812, demonstrating its strong economic strength and consumption power. Not to mention that the United States is a world leader in technological innovation, R&D, and talent cultivation, which means that its future economic growth potential is still very strong. Even if there is pressure on interest rates and debt in the short term, the growth momentum will still be sustainable in the long term.
Secondly, the dollar's status as the world's reserve currency provides unprecedented support for the U.S. sovereign credit. Although the voices of de-dollarization have heated up in recent years and the proportion of the US dollar in foreign exchange reserves has actually begun to decline, as of now, the US dollar still accounts for the dominant proportion of global foreign exchange reserves. As of the fourth quarter of 2024, the US dollar accounted for 57.4% of global official foreign exchange reserves. On the other hand, many international trade and financial transactions are denominated in US dollars, which allows the United States to continue issuing Treasury bonds at low cost without having to bear too high a risk premium. Compared with other sovereign states, the United States is better able to absorb high fiscal deficits and debts, and is still seen as a provider of safe-haven assets during market turmoil, which can significantly alleviate the immediate impact of its fiscal deterioration on borrowing costs.
Third, the independence of the Federal Reserve and the flexibility of its policy tools are also key stabilizing factors in Moody's assessment. Despite challenges in policy communication and forward guidance in recent years, the Federal Reserve remains one of the most credible and practical central banks in the world. Whether it is fighting inflation, providing market liquidity, or even when Trump is clamoring to replace the central bank governor, it still maintains its data-driven perspective to make policy responses. This allows Moody's to reasonably expect that even if the United States faces fiscal challenges, it still has the ability to make headwind adjustments through monetary policy to maintain overall macroeconomic stability.
Finally, although the political system is not perfect, it is still stable. In recent years, it is indeed difficult to understand what is going on in American politics, with problems such as the two-party struggle and budget difficulties continuing. However, Moody's believes that the US institutional design, such as the separation of powers and the constitutional structure, still has a certain insurance function. It can prevent major policy turns (?) and keep the overall policy direction from getting too out of control. In plain words, Moody's believes that the US political system is inherently quite stable compared to many countries.
In summary, the reason why Moody's was able to maintain a stable outlook while downgrading the rating is that the above-mentioned structural advantages have not been shaken. Although the United States faces fiscal and debt challenges in the short term, its economic size, depth of its financial system, institutional stability and global status constitute a solid firewall against current credit risks. In this context, even if the ratings are adjusted, the actual impact on the current market will be relatively limited.
Treasury auction performance after rating downgrade
After Moody's downgraded the US sovereign credit rating, the 20-year Treasury bond auction on May 21 became a key window for observing changes in investor confidence. However, judging from the results of various auctions, the overall performance can be rated as neutral to weak, indicating that the market's attitude towards long-term US Treasury bonds tends to be conservative.
First, the Bid-to-Cover Ratio is 2.46 times, which is within the normal range of the past few years, but it is lower than the previous average of 2.57 times, which still shows that demand has declined. Secondly, the highest winning bid rate (High Yield) of 5.047% is higher than the market expectation of 5.035%. In plain words, the market enthusiasm for this wave of U.S. Treasury auctions has declined, but bondholders are demanding a higher expected rate of return.
Figure 2: Detailed data on the recent sales of 20-year U.S. Treasury bonds (Source: Department of the Treasury)
Although the overall funds for purchasing U.S. debt have decreased in terms of subscription multiples, they are still much greater than the issuance amount. Overseas funds account for nearly 70%, and the proportion of direct subscriptions in the United States has actually increased. The overall capital participation rate is declining, but national central banks, pension funds and various large financial institutions continue to purchase U.S. debt even after the U.S. sovereign credit rating was officially kicked out of the ranks of Aaa-rated countries.
The author believes that the current decline in market enthusiasm for U.S. debt has little to do with Moody’s downgrade itself. In fact, most long-term funds such as central banks and pension funds continue to participate, indicating that the rating adjustment has not shaken the market's perception of the basic safety of US Treasury bonds. What the market is really worried about is the uncertainty in the outlook for US fiscal policy and the growing deficit in both stock debt and cash flows.
Especially with Trump returning to politics, his trillion-dollar tax cut plan has sparked widespread controversy. Trump advocates that tax cuts can make up for the tax gap by stimulating corporate investment and economic growth. However, with the current fiscal deficit at a historical high, the Democrats question whether the plan will exacerbate fiscal deterioration and cause debt momentum to spiral out of control. This bipartisan divide has deepened market concerns about future fiscal sustainability and has also caused some funds to turn to safe-haven assets such as gold that are resistant to inflation and credit risks to hedge against potential policy risks and real interest rate fluctuations.
The potential structural impact of the US debt downgrade on the future market
Although U.S. Treasuries remain the most widely used form of collateral in the market due to their high rating, liquidity, deep repo market and strong democratic foundation/rule of law. So what is the impact of the ratings officially leaving the Aaa club?
The most direct impact in the future is the loosening of U.S. Treasury bonds as the anchor of market pricing, which is also reflected in the fact that the highest winning bid rate of the above-mentioned 20-year U.S. Treasury bond auction was higher than expected. U.S. Treasury yields are traditionally viewed as a benchmark for global asset pricing. After the ratings downgrade, the Bloomberg Barclays Global Aggregate Index has reduced the weight of U.S. Treasuries from 38% to 35%, while increasing the weight of German government bonds to 22%. This adjustment resulted in a significant change in the cross-asset correlation coefficient: the negative correlation between the S&P 500 index and the 10-year U.S. Treasury yield weakened from -0.87 to -0.68, indicating a weakening of the pricing anchoring effect.
US 10-year Treasury yield vs. S&P 500 (Source:Bloomberg)
Although the United States no longer has the highest rating from any major rating agency, the impact on financial markets and institutional practices is relatively limited, mainly reflected in the gap between technical adjustments and institutional exceptions.
On the one hand, the investment policies of specific institutions will adjust their positions due to rating changes. For example, the Norwegian Sovereign Wealth Fund can only hold Aaa-rated sovereign bonds according to regulations, and its approximately US$54 billion in U.S. Treasury bonds must be disposed of within 90 days after the rating takes effect. According to estimates, such conditions affect about 0.3% of the total U.S. Treasury market, which will not cause a major impact on the market, and some of the forced selling pressure is expected to be absorbed by funds from other central banks and sovereign funds.
On the other hand, the impact at the supervisory system level is relatively mild. Under the Basel supervisory framework, banks using the standardized approach can still give a 0% risk weight to sovereign bonds rated between Aaa and AA-; even if it drops to Aa1, capital requirements will not change. Most banks actually adopt an internal risk rating model (IRB approach), and most jurisdictions still assign a 0% risk weight to their government debt. Therefore, from the perspective of capital adequacy ratio and risk-weighted assets, the downgrade of US debt will have little impact on banks.
In terms of liquidity regulation, U.S. Treasuries may face technical impacts of reclassification. Currently, most U.S. Treasury bonds are classified as Level 1 assets among high-quality liquid assets (HQLA), corresponding to the highest liquidity certification. If some institutions reclassify U.S. Treasuries as Level 2A assets based on their internal policies, the liquidity buffer ratio (LCR) will decrease. Taking JPMorgan Chase as an example, 68% of its HQLA portfolio in Q1 2025 is U.S. Treasuries; if 30% of them are reclassified due to rating adjustments, the bank will need to increase its holdings of approximately US$22 billion in additional Level 1 assets to maintain the 100% LCR requirement. This will boost replacement demand for other Aaa-rated Treasuries.
As for long-term investment institutions such as life insurance companies and pension funds, the adjustment pressure they face is relatively small because the U.S. bonds held by these institutions are mainly used for liquidity management and risk hedging, rather than purely based on ratings selection. However, some institutions may increase their allocation to other high-rated sovereign bonds to achieve better risk diversification.
Term premium: a direct impact channel for rating downgrades
Moody's downgrade of the US credit rating provides us with a good example of how bond yield composition reflects actual credit events. According to the traditional pricing framework, long-term bond yields can be broken down into three core components:
Bond yield = economic growth expectations + inflation expectations + term premium
The ratings adjustment showed different degrees of impact and changes, among which the term premium should be the most directly affected component. The increase was mainly due to the increased uncertainty at three levels: fiscal sustainability risks, doubts about the effectiveness of monetary policy, and geopolitical tensions. As Moody's clearly pointed out in its rating report, the ratio of US federal debt to GDP will rise from 98% in 2024 to 134% in 2035. This structural deterioration directly pushes up investors' compensation demands for long-term risks.
According to the New York Fed model, the term premium of the U.S. 10-year Treasury bond has risen from about 50 basis points at the beginning of 2025 to 75 basis points after the downgrade, hitting a ten-year high. This shows that although the US nominal rating has only been downgraded from Aaa to Aa1, which is still in the high credit quality category, the market's repricing of long-term risks has been actually reflected in the bond market.
Composition of 10-year US Treasury yield – Short-term interest rate expectations and term premium
In summary, the expansion of the term premium shows that the impact of the rating adjustment is not just symbolic, but has actually increased the holding cost of long-term assets. In the future, some long-term funds may shift to other sovereign bonds with stable credit and more attractive risk compensation, such as Aaa-rated government bonds of Germany, Canada or Australia.
Summarize
Moody's downgraded the US credit rating to Aa1, indicating that the three major credit rating agencies have comprehensively downgraded the US sovereign rating, highlighting its structural fiscal challenges. The ratio of debt to interest payments continues to rise, deepening market concerns about fiscal sustainability. Although the market reaction was relatively mild and Moody's adjusted the rating outlook to stable, it still reflects that the market still has confidence in the fundamentals of the US economy and the international status of the US dollar.
In the long run, this rating downgrade may become a key turning point for global capital to re-examine the "risk-free" positioning of US assets. Faced with high debt pressure and political deadlock, the United States urgently needs to promote fiscal reform to maintain international trust; global investors will pay more attention to fiscal discipline and diversified asset allocation, making emerging markets with good credit ratings and sound economies a new focus of funds. In addition to the renewed popularity of traditional safe-haven assets such as gold, digital assets such as Bitcoin hit an all-time high shortly after the U.S. debt rating was downgraded, indicating a rapid inflow of funds and reflecting the market's expectations for it as an emerging safe-haven tool. Bitcoin is regarded as one of the important safe-haven and diversification assets due to its decentralized and limited supply characteristics. As the global financial environment continues to be full of uncertainty, the risk-free nature of US debt, which was once considered risk-free, may have begun to be questioned (?)
