Moody’s downgraded the United States long-term debt rating to Aa1 from Aaa on Friday afternoon. On the more familiar S&P scale, this is the equivalent of downgrading one notch from AAA to AA+. Moody’s is the last of the three main credit agencies to lower the US to the equivalent of AA+. S&P lowered their rating about 14 years ago on 8/5/2011 and Fitch did it about 2 years ago on 8/1/2023.

1. To put this into context, consider the Average Numerical Credit Score (ANCS)

I’ve created a numerical score associated with each of the credit agencies’ ratings to convert the confusing alphabet soup of credit ratings into a single numerical score (see table below.) AAA or Aaa is a score of 9, AA+ or Aa1 is a score of 8, etc. Investment grade is anything over 0, junk or “high yield” is a score below 0. Positive or negative “watch” levels are considered 0.5 points.

The average of this score for the three main credit agencies represents the overall health of an entity and allows for a comparison between entities and over time. I call this the Average Numerical Credit Score (ANCS) which can be used for sovereigns or companies and importantly, allows the creation of a time series representing how the score has changed over time (more below).

2. The US’ ANCS credit score fell 0.3 on Friday and is still very high

Among G20 countries, after Friday’s downgrade, the US ANCS credit score continues to be fourth after Germany, Australia, and Canada. Among all 132 countries rated by S&P, the US is 13th but the twelve countries with higher ratings have a collective GDP less than half that of the US. Despite the downgrade, the US score is still very high at 8.0 (gray highlighted row).

Notice that these average credit scores (blue column) have a poor relationship with the level of interest rates in the country (amber column). For investment grade countries (ANCS >=0), sovereign interest rates are determined more by the outlook for inflation and economic growth than their credit score. Perhaps counter-intuitively, countries like Australia have a high credit score but also have relatively higher interest rates and countries like Japan or China have lower credit scores but relatively lower interest rates. Until a country gets close to a junk rating (fiscal dominance zone), interest rates generally stay low.

3. ANCS over time

Visualizing this ANCS figure over time for Japan and the US shows how many times and how deeply Japan’s credit rating was lowered in two waves between 1998 and 2015 from rising debt, all with falling government bond yields. It also shows how minor Friday’s downgrade is in comparison.

4. Initial market reactions to credit downgrades

In the 20 minutes that markets had to trade after Friday’s downgrade news was released, Treasury yields rose (10-year, +4 basis points.) What will the reaction be this week?

Japan was downgraded 19 times as shown in the chart above. Of those 19 times, the 10-year Japanese Government bond yield rose over the subsequent 5 business days 63% of the time, ranging from 1 basis point to 10. In the 37% of the time that the 10-year yield fell, it fell from 1 to 18 basis points. There isn’t a clear direction or magnitude, and I suspect yields continued reacting to whatever was going on with the economy at the time.

In the two times the US was downgraded, yields went opposite ways. In the 5 business days after the S&P downgrade in 2011, the 10-year yield fell 15 basis points, but the Lantern Daily Economic Index (LDEI) at the time was very low around -80 and falling; suggesting a weak economy may have been a greater factor. After the Fitch downgrade in 2023, the 10-year yield rose 6 basis points in the 5 business days after, but the LDEI was slightly positive and rising suggesting an improving economy may have been a factor.

Across these periods, there is no common reaction of government bond yields to credit downgrades.

5. Conclusion

The United States still has room on its balance sheet for more debt and as human nature goes, it will probably be used by politicians to avoid taxes—the path of least resistance. If this occurs, the United States will continue being downgraded as the debt to GDP ratio rises, but, from the example of Japan, it doesn’t mean Treasury yields will rise. Despite the furor, the US is a long way from a fiscal crisis.