What Does the Debt Downgrade Mean for the Economy and Real Estate?

Yesterday, the credit rating agency, Fitch Ratings, cut their rating on United States long-term debt from AAA (the highest rating) to AA+. This implies that the United States now has a slightly higher risk of default on issued long-term debt than in the past and a higher risk of default than countries such as Germany, Denmark, Netherlands, Sweden, Norway, Switzerland, Luxembourg, Singapore and Australia. Fitch Ratings had formerly had placed U.S. debt on a “negative watch” back in May due to the repeated debt ceiling brinkmanship in Washington, however this move signals the private agency’s harder stance on the country’s unsustainable debt burden as well as political negotiations that threaten to undermine the full faith and credit of our government to repay its debt on time and in full.

Why now? Ratings agencies are an extremely lagging indicator, noting their reasoning that there has been a “steady deterioration in standards of governance over the last 20 years, including on fiscal and debt matters..” There has been a sense for a long time that the amount of debt taken on to fund our government is concerning, as is the ability of divided government to agree on a solution to guarantee payment of our obligations indefinitely without using default as a negotiating chip on budget matters. Additionally, as interest rates increase, so do the debt service payments on newly-issued bonds, so this ratings downgrade might be partly in response to this fact.

These obvious concerns may have led the market to increase the pricing of longer dated treasuries slightly as the perceived risk of non-repayment appears to be greater than zero. However, do we really think United States treasury bonds have a higher default risk than say Germany’s or Singapore’s? Are they riskier than debt of companies such as Johnson and Johnson or Microsoft, who are rated AAA? Riskier than cash in the bank beyond the federally insured limit in the wake of recent bank failures? Of course not. We have never left work on a Friday and wondered whether our treasury bonds are going to be worthless or not on Monday like many Silicon Valley Bank customers faced a few months ago. I would say that U.S. treasuries are the safest investment out there and therefore should expect a rate of return marginally higher than inflation. If so, then why decrease the rating?

Fitch made this move as an attempt to gain credibility. Ratings agencies lost all credibility during the financial crisis when they rated the sub-prime loan bonds AAA and then most of them defaulted. Bond insurers relied on these ratings and basically blew up along with the sub-prime loans went into foreclosure. Companies looking to rate debt would use whichever ratings agency gave them the highest ratings and as long as the money was flowing, the ratings agencies, which are private companies, were incentivized to make it work (See The Big Short/AIG Bailout). Since then, the ratings agencies have been working hard to gain credibility and taking a stand here and dropping the U.S.’s credit rating is low hanging fruit when there is seemingly so much ammunition to create concern. It is a meaningless stand though because when the U.S does not default on their debt, Fitch is not going to be proven wrong. AA+ does not predict a default. If we do default, Fitch can say “we told you so” and we were the first one to do so.

So, what does this mean for the economy and real estate? Probably very little in the long term, but maybe higher interest rates in the short term. There has been an initial jump in 10-year bond yields, which 30-year mortgage rates tend to follow, however shorter term treasury yields were actually down, implying a slight flight to safety in the form of short-term treasuries. Bond yields are near their highest levels all year, however this is largely due to strong economic conditions decreasing the likelihood that the FED, who likely reached their terminal rate with last week’s 25 basis point hike, will not reduce rates in the near future. Receding inflation will have their effect on bond yields sooner or later. Markets are smart and efficient and the ratings agencies are not telling them anything that has not been a flashing red light for years. This will soon be forgotten and we should look towards current and future data to predict the path of interest rates and the real estate market.