What are the similarities and differences between the two downgrades of the U.S. bond rating in 2011 and 2023?

$NASDAQ(.IXIC)$ was down 2.17% yesterday after Fitch downgraded U.S. bond rating. By contrast, in August 2011, the $S&P 500(.SPX)$  Index fell by nearly 7% after S&P's US rating downgrade. Although the two downgrades both caused more volatility in the market, the US economy faced different problems during these two periods.

Similar economic conditions in 2011 and 2023

Before downgrades of the U.S. bond rating in 2011 and 2023, the government during both periods tended to increase public spending. Obama at that time advocated expanding government fiscal expenditure, investing hundreds of billions of dollars to strengthen infrastructure construction, establish universal health care, provide assistance to property buyers, etc., in order to create job opportunities and indirectly stimulate consumption.

Obama took office during the Great Recession. He immediately needed to spend billions to stop it. Congress added $253 billion from the economic stimulus package to Bush’s FY 2009 budget. The American Recovery and Reinvestment Act added an additional $534 billion over the rest of Obama's terms. Biden took office after the pandemic and had stimulus plans as well. Deficits of the government reached a new high under their governance.

The economy faces more challenging inflation worries now than in 2011

According to Federal Reserve Bank of Cleveland, 5-year expected inflation in 2011 was under 2.0% most of the time, but now the US inflation rate and its expectation is still above the target.

A recent rise in commodity prices has cast doubt on whether the Biden administration can keep inflation under control. Oil prices found support from EIA data showing US crude inventories declined by about 17 million barrels last week, the biggest draw since records began in 1980 and far exceeding market expectations for a 1.367 million barrel draw.

If the next economic cycle sees inflation stay at levels well above the post-GFC period (when inflation was consistently below target), 10-year yields are biased higher and yield curves steeper, well beyond near term issuance related influences.

The Fed's policy direction is opposite in 2011 and 2023

When S&P downgraded the U.S. debt rating in 2011, the U.S. had just completed the second quantitative easing; but when Fitch downgraded the U.S. debt rating in 2023, the U.S. was undergoing quantitative tightening. In this case, unlike in 2011, after the huge amount of bonds are issued, who will digest these bonds has become a problem. U.S. bond yields are more likely to rise in the short term.

Long-term yields rose more in 2023

While short-term yields rose in 2011 and long-term yields declined at that time, this year, the yield on the 10-year US Treasury note rose more significantly, above 4.15%, near November 2022. The difference is partly due to the issuance schedule. The rise in long-term debt sales will be front-loaded, with the biggest jump in 10-, 20- and 30-year debt coming this month. Issuance of shorter-maturity notes (2s, 3s and 5s) will rise in a steadier fashion. This makes sense if the yield curve is on its way to un-inverting itself at some point in the next year; it's better to sell more long-dated bonds when long-term rates are relatively low. Deutsche Bank framed this as “increasing term premium”, which is sort of a catchall term for a steeper (or less inverted) yield curve.

The differences also reflected that the market volatility in 2011 was more about pricing a recession than an overly strong economy like in 2023.

Just as the ADP number showed yesterday, 324 thousand private-sector jobs were added to the US economy in July, magnifying evidence of a strong labor market.

The Fitch downgrade may offer an opportunity for investors to take a breather.

Raphael Thuin, head of capital markets strategies at Tikehau Capital said “The market price reaction shows how markets are getting uncomfortable with the long-term sustainability of rising government debt. There's absolutely nothing new in what Fitch had to say but it puts the finger, in a moment where markets are somewhat febrile, on the issue of over-leveraging in a world of lower economic growth and higher yields. On the mid-term we will enter a cycle of deleveraging and that will progressively add some risk to the market.”

However, the Democratic and Republican parties had earlier reached an agreement to cut and limit some government spending in May, somewhat increasing fiscal sustainability.

Warren Buffett said today that he's not worried about Fitch's U.S. downgrade. He told CNBC,“Berkshire bought $10 billion in U.S. Treasuries last Monday. We bought $10 billion in Treasuries this Monday. And the only question for next Monday is whether we will buy $10 billion in 3-month or 6-month”.

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