Fitch Affirms U.S. Top Credit Rating, Outlook is Negative Due to Debt and Political Divide

Fitch Affirms U.S. Top Credit Rating, Outlook is Negative Due to Debt and Political Divide

One of the world's top rating agencies has sustained the United State's top credit rating, but issues warnings about the economic and political future of the country.

Fitch affirms the United States at 'AAA' rating, but gives America a "negative" outlook due to growing federal debt and political polarization.

This is an unprecedented rating report. 

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The rating agency, which generally focuses nearly exclusively on the financial performance and long-term outlook, raises significant concerns about the state of America's political governance.

"The failure of the former president to concede the election and the events surrounding the certification of the results of the presidential election in Congress in January, have no recent parallels in other very highly rated sovereigns. The redrafting of election laws in some states could weaken the political system, increasing divergence between votes cast and party representation," writes Fitch.

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The U.S. sovereign rating is supported by structural strengths that include the size of the economy, high per capita income and a dynamic business environment. The U.S. benefits from issuing the U.S. dollar, the world's preeminent reserve currency, and from the associated extraordinary financing flexibility, which has been highlighted once again by developments since March 2020. Fitch considers U.S. debt tolerance to be higher than that of other 'AAA' sovereigns.

The Negative Outlook on the rating reflects ongoing risks to the public finances and debt trajectory, notwithstanding the improvement in Fitch's fiscal and debt projections since its last review. Debt dynamics currently point to a broad stabilization in the debt ratio at a level where a further meaningful increase could lead to a downgrade. However, key variables including real interest rates and fiscal deficits may not follow the expected path, potentially creating downside risk. In light of developments since the last review and future risks, a deterioration in governance represents a further risk to the rating.

Governance is a weakness relative to the 'AAA' median, and the future direction of the rating is sensitive to the direction it takes. The failure of the former president to concede the election and the events surrounding the certification of the results of the presidential election in Congress in January, have no recent parallels in other very highly rated sovereigns. The redrafting of election laws in some states could weaken the political system, increasing divergence between votes cast and party representation. These developments underline an ongoing risk of lack of bipartisanship and difficulty in formulating policy and passing laws in Congress.

A stronger-than-expected economic recovery has led public finances to outperform Fitch's expectations at the last review, generating higher tax revenues and reducing the need for household transfers. Nevertheless, the general government deficit in 2021 will be 14% of GDP, only marginally down from an estimated 14.9% of GDP in 2020. Two rounds of pandemic relief, the first in December 2020 followed by the American Rescue Plan in March 2021, together authorized up to USD2.8 trillion in spending (including the re-allocation of USD429bn in unspent funds authorized by the March 2020 CARES Act), the large majority in fiscal years 2021 and 2022, which has not yet been fully executed.

A relative tightening in fiscal policy as pandemic relief spending rolls off is the key feature of Fitch's baseline fiscal forecasts. Fitch expects the general government deficit to narrow to 7% of GDP in 2022. Fitch has assumed that spending matches the CBO (current-law) baseline, but with 0.8% of GDP in spending added in both 2022 and 2023. The bipartisan framework on infrastructure agreed in late June would, if passed, add USD579 billion in new spending to the baseline over five years with partial revenue offsets.

A simple majority of 51 (Democratic) votes in the Senate could pass a further reconciliation bill that would include more spending, together with some revenue offsets. Fitch assumes that on a net basis this would add USD1 trillion to fiscal deficits over a decade. No fiscal 2022 budget resolution has been passed by the Democratic majorities in the House and Senate to date. In Fitch's view, future spending will fall considerably short of the administration's American Jobs Plan and American Families Plan.

Fitch expects the general government debt/GDP ratio to fall back slightly to 121% in 2021 based on nominal GDP growth exceeding 10% and the Treasury's drawdown of deposits to finance part of the deficit in fiscal 2021, so that new borrowing will be lower than the deficit. Debt dynamics point to a broad stabilization of the debt ratio around the 121% of GDP level, followed by a shallow increase from 2024 onwards. Between 2022 and 2031 the CBO July 2021 baseline includes a 1.3pp of GDP rise in spending on healthcare and social security, linked to demographic and healthcare cost factors.

Current debt levels are 20pp of GDP higher than pre-pandemic levels, representing an additional burden on public finances over an indefinite horizon. Yet at current borrowing costs debt service is just 6% of revenues (albeit much higher than 'AAA' rated peers), a similar level to the post-2008 average. Real borrowing costs are negative on a forward-looking basis with the current 10-year yield at 1.35%. However, such conditions cannot be guaranteed forever, with rates expected to rise over the medium term as Fed monetary policy stimulus is unwound. Under a scenario where real interest rates rose by 200 basis points compared with our baseline (which is steeper than that of the CBO) then the debt ratio would rise by 8pp of GDP by end-2025.

The debt limit suspension will expire at the end of July; Fitch assumes that it will be suspended again. There is no official estimate of the "x date" when "extraordinary measures" used to keep the government operating without incurring new debt will be exhausted. Treasury Secretary Yellen warned that this could fall in mid-August, while independent estimates put it one to two months later. Failure to raise the debt limit in time to prevent a default (in the absence of a formal way of prioritizing debt service) is a meaningful but remote tail risk to the rating.

The economy has recovered much more rapidly than expected, helped by policy stimulus and the roll-out of the vaccination program, which has allowed economic reopening. At the time of the last review, Fitch recognized the scale and speed of the policy response as a positive reflection on the macroeconomic policy framework. Real economic output has overtaken its pre-pandemic level and is on track to exceed pre-pandemic projections, despite the potential for scarring and a large setback to labor force participation that will restrain potential output. Fitch expects the economy to grow by 6.8% in 2021, and by 3.9% in 2022, well above a potential rate of 1.5%-2%. Risks to the economic outlook include a sharper than expected policy tightening, a shock originating in asset markets and a resurgence of the pandemic.

Inflation has picked up, with the annual rate of CPI reaching 5.4% in June (core inflation rose 4.5%), an accumulated rise in the price level of 3.6% in the first six months of the year. Some specific categories such as used cars and airfares, which have seen temporary and abrupt shifts in supply and demand, have made a major contribution. Fitch expects inflation to moderate over 2022-2023 while acknowledging upside risks from commodity prices, housing and supply bottlenecks. The unemployment rate was steady at 5.9% in June, even as 850,000 jobs were created during the month. Unemployment levels reflect a still-depressed labor force participation rate, given the still-high shortfall in the number of jobs compared with February 2020.

The Federal Reserve's new flexible average inflation targeting regime will welcome a period of inflation above 2%, to make up for past undershoots of inflation below the 2% target, and to ensure it is meeting the full employment part of its mandate. However, Fitch expects the Fed to begin to tighten policy by tapering the pace of asset purchases, which are running at USD80 billion a month of Treasuries and USD40 billion of agency mortgage-backed securities, before ending them entirely in 2022. Fitch expects the Fed will start to raise the policy rate in 2023.

ESG - Governance: The United States has an ESG Relevance Score (RS) of '5[+]' for both Political Stability and Rights and for the Rule of Law, Institutional and Regulatory Quality and Control of Corruption, as is the case for all sovereigns. These scores reflect the high weight that the World Bank Governance Indicators (WBGI) have in our proprietary Sovereign Rating Model. United States has a high WBGI ranking at 81.9 (82nd percentile) reflecting its long track record of stable and peaceful political transitions, well established rights for participation in the political process, strong institutional capacity, effective rule of law and a low level of corruption.