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Market Update

Continued U.S. economic growth and the Fitch downgrade result in higher long-term rates

August 7, 2023
  • amol dhargalkar headshot


    Amol Dhargalkar

    Managing Partner, Chairman
    Global Head of Corporates

    Kennett Square, PA


The U.S. economy and labor market continue to show resilience. On the back of a variety of economic releases and the Fitch downgrade, heightened volatility occurred last week, which ultimately resulted in the yield curve starting to reflect that a soft landing is attainable. As a result, short-term treasuries fell, long-term treasuries rose, the yield curve became slightly less inverted, and the dollar strengthened.

Fitch downgrades the U.S. credit rating

After placing the U.S. credit rating on "rating watch negative" back on May 24, 2023, Fitch formally downgraded U.S. credit from AAA to AA+ last Tuesday evening. In its release, Fitch quoted “expected fiscal deterioration over the next three years, a high and growing general government debt burden, and the erosion of governance” as the factors leading to the downgrade. Notably, Fitch expects the government debt to GDP ratio to reach 118.4% by 2025, 6.9% of which is expected to be added in 2025 alone. Additionally, they expect the interest-to-revenue ratio to hit 10% by 2025, which is well above the 1% median for AAA- rated institutions.

Unlike in 2011, when Standard and Poor's downgraded U.S. credit, the market had a more predictable reaction this time around. After the downgrade in 2011, demand for bonds ironically increased and yields on the 10-year U.S. Treasury fell over 24 basis points as investors sought safety. However, on Wednesday last week, the first trading day after Fitch's downgrade, the 10-year U.S. Treasury rose, as expected on a downgrade, by 2.7 basis points. By Thursday, in combination with strong economic data, the 10-year treasury rose to over 4.19%, its highest level since November 2022.

Unlike in 2011, the market seemed to assign an additional risk premium to long-term treasuries succeeding the Fitch downgrade. The debt ceiling debate earlier this year, which spurred the Fitch rating watch, resulted in a similar outcome. During the political gridlock, the 10-year treasury increased 42 basis points in less than three weeks due, in large part, to the deteriorating faith in the U.S. government. It appears the market is starting to charge Congress for its spending habits and legislative indecisiveness.

US economic strength continues

In addition to the Fitch downgrade, last week's positive economic data spurred an increase in long-term yields as another wave of employment data showed economic resilience and implied a soft landing is still attainable. On Tuesday, the ADP employment survey reported an estimated 324,000 jobs were created in July, which significantly exceeded the Dow Jones estimate of 175,000. On Friday, the Bureau of Labor Statistics (BLS) reported an estimated 187,000 jobs were created, which was lower than the estimated 200,000, but the unemployment rate still slid to 3.5%.

Both reports showed that the labor market continues to be robust, but also showed notable cooling in wage gains. The ADP reported wages increased at their slowest pace year-over-year since November 2021 at 6.2%. Similarly, the annual wage increase in the BLS report was within 0.1% of its lowest reported level since July 2021 at 4.4%. Job openings also hit a 2-year low at 9.58 million.

The job numbers continue to show a goldilocks scenario for the U.S. economy. Job growth remains persistently positive, but at a decelerating rate, and job openings are trending towards historic norms. Likewise, wages are still increasing but at a slower pace, which allows consumers to continue spending but at a rate that should not spur dramatic inflation. The reports are good news for both the U.S. economy and the Federal Reserve.

Economic resilience can also be seen in real GDP figures. Real GDP for Q2 2023 was revised upward two weeks ago to 2.4% by The Conference Board, far exceeding the 1.8% estimate. More notably, the Atlanta Fed GDPNow estimate reported last week it expects Q3 2023 real GDP will be 3.9%. That estimate was also revised upward from 3.5% on July 28.

If true, the Atlanta Fed estimate would mean real GDP on an annualized basis is projected to grow at its fastest rate since the last quarter of 2021.

Treasuries, swap rates, and the dollar index all move up and to the right

The additional risk premium and improving U.S. economic outlook has helped to reduce the inversion in the yield curve. Last week, the spread between the 10-year and 2-year treasury improved to negative 70 basis points, its smallest inversion since May. As a result of the labor reports, the market is increasingly expecting no additional rate hikes from the Federal Reserve, which has resulted in a week-over-week decline of 10 basis points in the 2-year treasury yield. Meanwhile, the improving overall economic outlook and additional risk premium following the Fitch downgrade has spurred a rise in longer term interest rates with the 10-year treasury yield increasing 10 basis points. With longer-term rates rising, the dollar strengthened, resulting in the dollar index hitting its highest level since July 7.

Looking ahead

The recent movements in rates were not without volatility. Last week, the 10-year treasury traded within a range of 3.92% and 4.19%. With the market’s increasing attention to economic releases, particularly labor and inflation reports, volatility will continue. Many clients, both corporates and real estate alike, are hesitant to lock in current fixed rates. However, it is important to keep in mind that many market participants expected a recession to begin in the current quarter. The reality is the U.S. may experience its best economic growth on an annual basis since 2021. In an environment where interest rates are moving nearly 30 basis points in a given week, foreign exchange forward curves are continuously being revised to reflect new economic realities around the world, and commodity prices, particularly oil, are increasing, organizations should review their hedging programs to ensure they can tolerate the increasingly unpredictable world. In the coming week, the consumer price index, as well as the producer price index, will presumably cause additional volatility as the market digests the results.

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