US credit rating downgrade hits US dollar

The US dollar lost ground at the beginning of the week as traders questioned whether the US’s soaring debt can be sustained. The US Dollar Index came under pressure close to the 100.00 mark. As a result, sentiment turned bearish across major pairs.

The US Dollar Index (DXY) which measures how the USD performs in relation to six other major currencies moved lower, towards 100.30. Markets’ lack of trust in the greenback has caused the DXY to decline.

Moody’s said in its report that the US has significant economic and financial strengths. However, it added that these strengths no longer fully counterbalance the decline in fiscal metrics, Reuters reported.

US Treasury yields

US Treasury yields remained elevated after Moody’s downgrade with rates hitting key levels and weighing on financial markets. The 30-year Treasury yield reached around 5.03%, which was last seen in November 2023. The 10-year yield also rose 2 basis points to 4.459%. The 2-year Treasury yield dropped by 1 basis point to 3.972%.

Market participants recovered from the news by buying bonds and driving yields lower from their highs.

Federal Reserve rate cuts

The greenback came under pressure partly due to growing expectations that the Federal Reserve (Fed) will soon start cutting rates because of inflation easing. The downgrade expresses widespread concerns regarding fiscal deterioration and distortions caused by Trump’s tariffs.

Fed officials have warned that they need to be cautious before making any policy changes. This caution has helped provide support for the dollar.

According to the CME FedWatch tool. Markets now price in a 91.6% chance of maintaining rates at 4.25%–4.50% in June. There is also a 65.1% chance of no change in the July meeting.

US government debt

Pressure on government debt may increase as a result of the US credit rating downgrade. The decline in Moody’s triple-A rating coincides with worries about the budget deficit’s growth and fiscal trajectory.

Last Friday (16 May), Moody’s downgraded the US and issued a warning about growing government debt and a growing budget deficit, dealing a blow to Washington. As the final of the three major agencies to downgrade the US from a triple-A rating, it lowered the country’s credit rating by one level to AA1.

Trump’s spending bill to add trillions to budget deficit

This week, House Republicans pushed ahead with Trump’s tax and spending bill. The bill is expected to add trillions to the budget deficit.

Moody’s warned about this in its downgrade: “Successive U.S. 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.”

The US national debt now stands at $36 trillion (£27 trillion). Economists worry that Donald Trump’s “one big, beautiful bill” could increase the deficit by cutting taxes.

Moody’s added about US dollar:

“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’s fiscal performance is likely to deteriorate relative to its own past and compared with other highly rated sovereigns.”

The US treasury secretary, Scott Bessent, tried to minimise the significance of the downgrade by telling NBC’s Meet the Press show that “Moody’s is a lagging indicator.” In an interview with CNN, he also noted that, “I don’t put much credence in Moody’s,” highlighting Trump’s administration’s confidence in the strength of the US economy.

US debt levels and market impact

Market participants anticipate that the downgrade won’t affect markets for long, but, nonetheless, it has drawn attention to the worrying US debt levels.

Over the past few years, US government debt has weakened and as a result, prices have decreased, raising the yield, or interest rate, on 10-year Treasury bonds to nearly 4.5%.

When prices decline, yields increase. Some analysts have argued that the downgrade may point to investors demanding higher yields on Treasuries, which could lead to increased selling pressures.

Regulators do not typically distinguish between triple-A and AA1 when determining capital risk weights. This indicates that the rating change is unlikely to have an impact on banks’ risk-weighted capital asset calculations.

Can the US Really Default? Credit Ratings vs Monetary Power

When S&P became the first major credit agency to deprive the US of its credit rating, stock markets plummeted in 2011. The following trading day, the S&P 500 index fell more than 6%. In 2023, markets also declined when Fitch downgraded its US rating from triple-A to AA+.

Other analysts feel that Moody’s downgrade may make investors more cautious.

Steven Cheung, the director of communications for the White House, criticised the downgrade, saying: “Mark Zandi, Moody’s economist, is an Obama adviser and Clinton donor who has been a Never Trumper since 2016.”

However, Zandi is not with Moody’s ratings division; rather, he is the chief economist for Moody’s Analytics.

Given that the US issues the US dollar, some investors argued that the US could not be made to default on its debt. With the US government issuing debt in a currency it prints and controls, and because it is the global reserve currency, analysts have said that it is impossible to default when your central bank can create settlement liquidity with a keystroke.

US exceptionalism takes a hit

A lethal cocktail of trade-related uncertainties, growing fiscal debt and waning confidence about US exceptionalism have weakened US assets, and pushed the dollar lower.

Now, investors expect the greenback to lose some of its appeal as it gets thrown down from lofty valuations, Reuters reported on 19 May. Indeed, the downgrade and Trump administration’s policy manoeuvres could push the dollar lower, analysts have speculated.

One of the reasons around the dollar’s weakness is that the currency has been trading at a relatively rich valuation. In January, it was as high as 22% above its 20-year average of 90.1 on the dollar index. Currently, the index is around 10% above its 20-year average level.

For many investors and strategists, the dollar has been overvalued for years, and this could be about to change. As Steve Englander, head of global G10 FX Research at Standard Chartered in New York, said: “The dollar weakness story is not over.”

Disclaimer: This information is not considered as investment advice or an investment recommendation, but instead a marketing communication. IronFX is not responsible for any data or information provided by third parties referenced, or hyperlinked, in this communication.