A Nearly Clean Getaway

Moody’s was the last of the big credit agencies to downgrade U.S. debt, revising it from AAA to AA1. This cycle started in 2011 when S&P downgraded the U.S. amid the debt ceiling showdown, and Fitch then followed suit in 2023 after the most recent debt ceiling debacle. Moody’s reasoning: the failure of the U.S. to address perpetual and large fiscal deficits. Based on the market’s reaction, or lack thereof, this observation was not a surprise to anyone. And with no fiscal relief in sight, it is unlikely that we will see a debt upgrade back to AAA in the foreseeable future. 

In essence, this leaves us with a less-than-risk-free “risk-free” rate, and this is important in a few ways:  First, it likely means that longer-term interest rates will be higher for longer, reflecting a higher risk premium that investors will require to hold U.S. Treasury debt. This will increase borrowing costs. Second, the increased borrowing costs will have a very direct impact on consumers, primarily through auto loan rates and, critically, through the mortgage market. The 30-year mortgage has remained stubbornly around 7%, and many have been waiting for relief that may not come soon. Third, the higher rates will put pressure on the deficit, exacerbating the pressure that interest expense puts on the U.S. budget. Currently, interest payments comprise roughly 14% of total expenses for the U.S., surpassing both national defense and Medicare. And fourth, risk assets across credit and equity markets are priced relative to the risk- free rate, and a higher U.S. Treasury rate may translate to higher risk premium across the board. While financial markets appear to be dismissing the importance of the last downgrade, we are mindful of the longer-term impacts.

Longer-dated U.S. Treasuries have borne the brunt of the recent selloff, driving the 30-year yield over 5% and, aside from a brief moment in October of 2023, to the highest level since 2007. The market narrative has focused on profligate U.S. spending and trade uncertainty driving long-term yields higher, but the U.S. is in good company when it comes to higher rates. Longer-dated German bunds, UK gilts and Japanese government bonds have all seen notably higher yields in the last seven weeks and, in particular, the month of May. "Higher for longer" has quite literally been a longer-dated trend across developed markets.

The U.K. in particular has seen higher rates since the September 2022 “Liz Truss moment,” when the former and short-tenured prime minister released a budget that included unfunded tax cuts, driving gilt yields up a full 1% in only four days and ushering in a near panic in the bond market that required intervention from the Bank of England. Since then, yields have remained generally rising and stubbornly high. In looking across many developed markets, there are certainly specific and relatively idiosyncratic reasons for higher yields, but the thread that runs through all of the narratives — including the rise in longer-dated U.S. Treasury yields — is the degradation in fiscal outlooks.  

Reflecting obvious frustration regarding the lack of progress being made in formalizing a trade deal between the U.S. and the EU, President Trump announced Friday morning that the U.S. would impose a 50% across-the-board tariff against the trading bloc starting on June 1. This is a tangible follow-up to an admonishment by Treasury Secretary Bessent last week that suggested the EU was not negotiating in good faith. If the 50% rate sticks, it would raise the effective aggregate tariff rate on U.S. imports to 17% from 12%. Recall that the pre-inauguration rate was below 3%.

As we have noted, tariffs are taxes, and taxes represent an inflationary impulse and a growth headwind. As such, the latest re-escalation with the EU will keep economic forecasters on their toes, once again, in assessing whether the impact will be enough to move the odds of a U.S. recession. We still think the odds of a U.S. recession in 2025 are roughly 50%. That said, the impact on the EU may be more meaningful, and, given the very weak economic starting point, it is possible that this additional headwind to growth may tip the bloc into recession. The EU has significant fiscal firepower and a Central Bank that is more inclined to lower policy rates in the face of any weakness, so there are potential offsets. However, the macroeconomic threat is real enough that we can anticipate a quick trip back to the negotiating table.

The persistent uncertainty on trade will continue to create significant noise in the economic data, with companies aggressively pulling forward, or pushing off, inventory accumulation and investment with high stakes at play regarding corporate margins and profitability.  In the meantime, U.S. consumers continue to spend, although the pace of spending seems to be slowing and largely supported by high-income households. Credit agencies and banks are reporting growing stress across auto loans and credit cards, and the resumption of collections and the end of Pandemic-era relief for student loans is creating financial pressure for over 5 million borrowers who are in default and 4 million who are in late-stage delinquency. 

Households have reflected economic concerns in myriad survey data, but we have not seen actual weakness across the economy. That said, the recent earnings release from Target may provide a cautionary tale for the future of consumer spending. While we appreciate the insights we can glean from a company like Walmart in providing a window into the health of the overall U.S. consumer, Target offers particularly interesting information given its concentration in a more discretionary product mix. That is, Target sells more “wants” than “needs,” and in a period of uncertainty or economic slowdown, we tend to see weakness across discretionary categories first. Further, Target appeals to a higher-end consumer, and these households will forego a visit to Target in favor of Walmart if confidence is waning. Most recently, and in the context of a disappointing quarterly earnings announcement, Target reported a more “choiceful” consumer — with growing caution across wealthier households and a comparable store sales decline of nearly 4%. With inflation remaining sticky and even potentially rising with tariff-related pressures, and as interest rates stay high, consumers will likely focus on value for their spend.