In a Friday night surprise, Moody’s (NYSE: MCO) downgraded the credit rating of the United States government one notch from “Aaa,” its highest rating, to “Aa1.” Moody’s has 21 grades in its ratings scale. Moody’s is the last of the three major credit rating agencies to downgrade U.S. credit.
S&P Global (NYSE: SPGI) downgraded the U.S. back in 2011, followed by Fitch in 2023. While the timing of the downgrade may have surprised some, Moody’s had previously warned about a downgrade earlier this year, citing growing fiscal deficits and elevated levels of total debt. On Monday, following the downgrade, the stock market seemed to take the bad news in stride, although traders in the Treasuries market do not seem to be happy with the news.
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Here’s what history says happens to the stock market next.
The U.S. has too much debt
Given that the U.S. ran over a $1.8 trillion deficit in fiscal year 2024 and has over $36 trillion in total debt, these issues are not new. They have, however, found themselves more in the spotlight in recent years. The trends do not seem to be reversing, and many experts believe continuing on like this is unsustainable long term. Moody’s in its press release on the ratings change said:
Successive US administrations and Congress have failed to agree on measures to reverse the trend of large annual fiscal deficits and growing interest costs. We do not believe that material multi-year reductions in mandatory spending and deficits will result from current fiscal proposals under consideration. Over the next decade, we expect larger deficits as entitlement spending rises while government revenue remains broadly flat. In turn, persistent, large fiscal deficits will drive the government’s debt and interest burden higher. The US’ fiscal performance is likely to deteriorate relative to its own past and compared to other highly rated sovereigns.
Moody’s noted that fiscal deficits could reach 9% (currently around 6.4%) of gross domestic product (GDP) by 2035, while the total debt will rise to roughly 134% of GDP by 2035, a level higher than it was during World War II. Annual interest payments on the debt, which amounted to 18% of revenue in 2024, are projected to rise to 30% by 2035.
Image source: Getty Images.
Moody’s also cited House Republicans’ “One, Big, Beautiful Bill,” which is attempting to make temporary tax cuts established in the 2017 Tax Cuts and Jobs Act permanent, along with new tax cuts as well. Moody’s estimates an extension would result in an additional $4 trillion to fiscal deficit, excluding interest payments, over the next decade.
What will happen to the stock market?
Given that the U.S. credit rating has been downgraded twice before this, we can take a look at how the broader benchmark S&P 500 has responded in these past scenarios. The first downgrade came after the Great Recession. S&P Global, formerly Standard & Poor’s, cut the U.S. credit rating from “AAA” to “AA+” on Aug. 5, 2011, on fears about fiscal deficits. Here’s what happened to the S&P 500 over the next year.
Data by YCharts.
As you can see, the market initially sold off intensely. But things quickly rebounded and got back to business as usual. Now, here’s what happened after Fitch downgraded U.S. credit from “AAA” to “AA” on Aug. 1, 2023, again citing debt concerns. The reaction over the next year?
Data by YCharts.
This time, the market also sold off intensely and briefly entered correction territory. However, the market then rebounded strongly. I don’t think the market took the credit downgrades as good news but rather glossed over them. The big reason for this could be the fact that the U.S. is the world’s reserve currency, so if the country defaults on its debt, it would likely be bad for everyone.
The country’s concerning debt situation has been well documented at this point, which is perhaps why the market had a muted response. Moody’s had warned about a potential downgrade earlier this year, so it’s not that big of a surprise. The big immediate concern is that investors of U.S. debt in the Treasury market will drive bond yields higher, making it more expensive for people to borrow and likely hurting the stock market as well. But, of course, there’s no guarantee that will happen.
There’s also no guarantee the market can keep ignoring the country’s fiscal issues. History often rhymes, but it doesn’t typically repeat itself. While the market does not seem overly concerned about debt issues, one can never know when the dam might break.
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Bram Berkowitz has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Moody’s and S&P Global. The Motley Fool has a disclosure policy.
