US: Aaa No More!

Expect Further Increase in Fiscal Deficit

The United States’ sovereign rating was lowered from a risk-free Aaa to Aa1 by the Moody’s rating agency on May 16. The reason Moody’s provided was that debt and interest costs are rising to a level “significantly higher than similarly rated sovereigns.” The reduced rating was neither the first US downgrade by a major rating agency nor was it unexpected. Standard & Poor’s had deprived the US of its top rating as long ago as August 2011 and Fitch had followed in August 2023.

Moody’s move was also not a surprise because the United States had already been on its credit watch due to the federal government’s burgeoning interest expenses. For the first time ever, interest payments on debt exceeded defense spending during calendar year 2024, and the $1.1 trillion run rate for annual interest payments is expected to keep rising in coming years.

When rating agencies downgrade countries — and I have watched several of them during my career — that typically increases the governments’ borrowing cost. The lower rating is supposed to encourage greater discipline in the budgeting process, with governments hoping to eventually restore their credit standing and reduce interest expenses.

That has not quite how it has worked out with the United States in the aftermath of the Moody’s move.

Moody’s downgrade notwithstanding, President Donald Trump repeatedly urged Republicans in the House of Representatives to vote for his “big, beautiful bill” that would extend the 2017 tax cut which had been due to expire at the end of the year. The bill would also eliminate taxes on tips and increase spending for defense and border security. The impact will be an estimated $3 trillion addition to the deficit over the next decade. The bill passed by a thin 215 - 214 vote in the House and now goes to the Senate for consideration.

Reacting to the likelihood that bond issuance by the US Treasury will have to increase substantially over the coming years to cover the fiscal gap, the yield on 30-year obligations rose as high as 5.15% intra-day on Thursday — the highest level since 2007. But are Treasury investors making an error in judgment? Could the tariffs provide the necessary additional revenue to Uncle Sam and lower the fiscal deficit despite the proposed tax reductions?

This is the administration’s view as Kevin Hassett, Director of the National Economic Council, explained on Fox Business on Monday as he predicted a “liftoff” for the US economy. Hassett expects economic growth to be “way north” of 3% during the second half of the year, possibly even above 4%.

Optimism was also the hallmark of Treasury Secretary Scott Bessent’s interview with David Westin on Bloomberg TV yesterday. Bessent suggested that several trade deals will be unveiled over the coming weeks, with Trump’s latest threat of a 50% tariff on the European Union merely a negotiating strategy to make EU officials move faster toward a deal. The fly in the ointment with this argument is that no tariff deal appears to provide a permanent solution and is always subject to change by the President at a moment’s notice. A second problem is that the President contradicted his Treasury Secretary and announced that he meant for the 50% EU tariff to stick and that he was “not looking for a deal.”

Frequent shifts in US trade policy combined with repeated climb downs from tough stances have made foreign counterparts play for time knowing that a rise in US Treasury yields and a growing risk of recession would make President Trump back off from his initial hawkish positions. At the same time, the back-and-forth on tariff threats will worsen supply bottlenecks as American manufacturers lack clarity on US trade policy. Witness Apple’s quandary. It decided to make parts out of India to escape the Trump tariffs on China, only to have the President threaten to impose a tariff of at least 25% on iPhones that Apple would import from India.

What is the responsibility of the Federal Reserve under these circumstances? Senior central bank officials, from Chairman Jerome Powell on down, have made a virtue out of not lowering rates further until there is clarity on the trade front. Chicago Fed President Austan Goolsbee made this point on CNBC yesterday. If he is really so concerned about tariff uncertainty, does it not behoove him, a voting member of the Federal Open Market Committee this year, to vote to raise the Federal Funds rate at the next meeting on June 17 - 18?

Just a thought. I do not really expect such courage or political independence on the part of the Federal Reserve.

Dr. Komal Sri-Kumar

President, Sri-Kumar Global Strategies, Inc.

Santa Monica, California

www.srikumarglobal.com

@SriKGlobal

May 24, 2025

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