Fitch downgraded U.S. debt, and the stock market slid. Here's what it means.

America's sovereign debt is considered the gold standard by investors and nations across the globe, with Treasuries viewed as a source of safe and stable returns. But on Tuesday, that sense of security was shaken when credit agency Fitch Ratings cut the nation's debt from its highest level. 

The decision roiled markets on Wednesday, with the Dow falling almost 1% and the tech-heavy Nasdaq shedding about 2% of its value. Treasury prices also fell on the downgrade, which Fitch attributed to the nation's swelling debt, serious fiscal challenges and what it described as a "steady deterioration in standards of governance" in the U.S.

The ratings cut, the first for U.S. debt in more than a decade, immediately drew objection from the Biden administration, with Treasury Secretary Janet Yellen saying she "strongly disagrees" with Fitch's rationale. Indeed, the timing of the downgrade may seem puzzling given that the U.S. isn't currently in a political deadlock over spending, as lawmakers were during debt ceiling negotiations earlier this year, or facing another imminent crisis. 

The "timing surely caught everyone off guard," noted Edward Moya, senior market strategist at OANDA, in a note to investors, adding that Fitch had previously warned it could downgrade the nation's debt. Here's what experts are saying about the impact of the downgrade. 

Why did Fitch downgrade U.S. debt? 

Fitch, which cut the U.S. credit rating a notch from to "AA+", from its previous "AAA" level, cited long-term challenges facing the nation.

The agency, which along with rivals like Moody's and Standard & Poor's evaluates the creditworthiness for governments and businesses, pointed to the bitter partisan gridlock that has prevailed in Washington in recent decades. 

"The repeated debt-limit political standoffs and last-minute resolutions have eroded confidence in fiscal management," Fitch said.

The most recent of these standoffs came earlier this year over the so-called debt ceiling, when the U.S. risked defaulting as Democrats and Republicans battled over how much the federal government can borrow to pay its debts. Within days of a potentially catastrophic default, GOP lawmakers and President Joe Biden struck a deal to avert a crisis.

Why did the downgrade happen now?

Fitch also cited factors including the nation's "complex budgeting process" and lack of medium-term financial planning. Of course, none of these are immediately pressing issues. But market observers noted that Fitch had warned two months ago that it was considering a downgrade. The firm also cut its rating after a recent Treasury Department announcement that it plans to increase borrowing.

"Fitch's downgrade followed the announcement by the U.S. Treasury on Monday, July 31 that it plans to borrow a higher-than-expected $1 trillion in the third quarter and will release the details of its plans on Wednesday," noted Marc Dizard, chief investment strategist for PNC Asset Management Group, in a report. 

What does Wall Street think about the downgrade?

Stocks fell on Wednesday, but Wall Street economists and analysts expect the short-term impact to be muted. 

"The market reaction so far is a far cry from that in the summer of 2011, when S&P became the first of the three main rating agencies to downgrade its rating of US sovereign debt," analysts with Capital Economics told investors.

When S&P cut the U.S. credit rating in 2011, the S&P 500 dropped about 15% with in a month, it noted. Investors may be more focused on Friday's jobs report, which will inform the Federal Reserve's decision on whether or not to boost interest rates at its September meeting, the group added. 

Alec Phillips, chief political economist at Goldman Sachs, told clients that the "downgrade contains no new fiscal information." Notably, Fitch's outlook is based on projections from the Congressional Budget Office — not new information that might indicate an near-term deterioration in the the U.S. financial stability. 

What does the Biden administration say about the cut? 

Treasury chief Janet Yellen on Wednesday pushed back against the downgrade, calling it "flawed" and "based on outdated data."

"Fitch's decision is puzzling in light of the economic strength we see in the United States," she added, citing data such as the nation's low unemployment rate of 3.6% and the 13 million jobs created since January 2021. 

Have the other credit agencies changed their ratings? 

Not yet. Moody's has maintained its rating on U.S. debt at "Aaa." S&P's rating remains at AA+, where it left the rating after cutting it in 2011, according to LPL Financial.

Still, some analysts say that downgrades from other ratings agencies could be in the cards.

"[C]ontinued fiscal expansion/deficits could result in additional downgrades from rating agencies," noted Lawrence Gillum, chief fixed income strategist for LPL Financial, in a report. "So, until the U.S. government gets its fiscal house in order, we're likely going to see additional downgrades."

Will Fitch's downgrade impact people's investments? 

Although markets dropped on Wednesday, Wall Street analysts said they don't believe Fitch's cut alone is likely to have a near-term impact on financial markets. 

"While not necessarily wrong in its assessment, the rating downgrade will likely not have an impact on U.S. government debt or markets broadly," Gillum of LPL said.

He added, "The U.S. remains the safe haven during times of market stress and the downgrade will likely not change that."

Even so, the downgrade, especially if followed by additional ratings agencies, could undermine investors' faith in U.S. debt and the stability of markets more broadly in the long-term, experts note.

What could it mean for taxpayers?

Many pension and other investment funds have rules that only permit them to hold investments with high credit ratings. If the rating for a given city or state fell too low, those investment vehicles would be forced to sell any holdings of those bonds. That could lead to higher borrowing costs for those governments as investors demand a higher rate of return to offset the higher risk. 

Similarly, eroding confidence in Treasuries could force the U.S. to pay higher interest rates, which would raise borrowing costs for the government and for taxpayers.

—The Associated Press contributed to this report

In:
• United States Department of the Treasury