The stock market got off to a rocky start on Wednesday. Major indexes fell across the board, with the Nasdaq Composite (^IXIC 2.02%) leading the way lower with a drop of nearly 2.5% at midday. Other stock market benchmarks posted somewhat more modest declines.
The move came in the aftermath of news from late Tuesday that the credit rating of the sovereign debt issued by the U.S. Treasury had been downgraded. After initially downplaying the decision from credit rating agency Fitch Ratings, stock markets later moved lower, while bond market yields climbed.
Here's a closer look at what happened and whether you and other investors should be concerned about the downgrade.
What Fitch Ratings is saying about U.S. debt
Fitch Ratings is one of three major financial institutions that issue bond ratings. Late Tuesday afternoon, the rating agency downgraded its long-term issuer default rating on the United States of America from AAA to AA+.
Fitch cited several factors for its decision. Fiscal conditions are likely to deteriorate over the next three years, as elevated budget deficits cause ratios of outstanding debt to gross domestic product to rise toward 120%.
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Moreover, Fitch pointed to an "erosion of governance" that has resulted in numerous threats, including the just-concluded debt ceiling debate and various government shutdown episodes over the past 20 years. In its view, Fitch sees these repeated crisis situations as having eroded confidence in the country's fiscal management more broadly, particularly because of the lack of long-term budget planning.
The U.S. also faces plenty of potential problems, both in the short term and long term. Rising interest rates have caused the amount that the Treasury has to pay in interest on the national debt to skyrocket, contributing further to annual budget deficits. If inflation remains stubbornly high, further rate increases could be necessary, which would only exacerbate the problem.
Even worse, if the U.S. economy falls into recession, it could result in a reduction in tax revenue and further hurt the government's fiscal condition.
Fitch also noted that intermediate-term fiscal issues remain unresolved, most notably the depletion of the Social Security and Medicare Trust funds within the next 10 to 12 years.
The solution, as Fitch sees it, is implementing measures to address mandatory spending increases or to boost revenue. It would take a "sustained reversal" in governance practices, however, to address its concerns about structural problems with the U.S. government.
The response to the U.S. debt downgrade
Many policymakers took the news negatively, arguing that the resolution of the debt ceiling debate in the late spring was contrary evidence to the assertions that the government's fiscal mechanisms were broken. Both the Treasury Department and the White House criticized Fitch for its decision.
Yet there was a definite delayed reaction in most financial markets. Stock index futures suggested a much smaller decline at the open of trading on Wednesday morning. Bond yields didn't start moving upward in earnest until midmorning, pushing the rate on 10-year Treasuries to nearly 4.1%.
One reason for the lack of panic was that Fitch wasn't the first credit rating agency to downgrade U.S. sovereign debt. Standard & Poor's did so more than a decade ago, and the response then was equally muted.
Meanwhile, there were few signs that lawmakers would take the steps Fitch suggested to improve the nation's financial situation. Political considerations have been paramount recently, and it's easy to assume that they will remain so indefinitely.
All in all, Fitch's decision to downgrade U.S. government debt is likely more symbolic than meaningful. It only draws attention to trends that have been ongoing for years now.
Investors don't need to pay much attention to the downgrade in and of itself. Most market participants have already acknowledged the structural challenges that the U.S. and other countries face in the current economy, and they're likely to persist for some time unless Washington suddenly pays more attention to fiscal matters than it has up until now.
