U.S. Debt Downgraded: What It Means and Why Markets Will Likely Recover
Here we go again. For only the second time in modern history, the United States has lost its pristine AAA credit rating from a major agency. Moody’s, the last of the “Big Three” to maintain the top rating, downgraded U.S. Treasuries to Aa1 in May 2025, citing unsustainable debt levels and rising interest costs1. This move follows similar downgrades by S&P in 2011 and Fitch in 2023. While the immediate market reaction has been turbulent, history offers a roadmap for what may lie ahead.
Historical Market Reactions to Downgrades
When S&P downgraded the U.S. in August 2011, the stock market plunged. The S&P 500 dropped nearly 7% in a single day, and volatility spiked. Yet paradoxically, U.S. Treasuries rallied as investors sought safety amid global uncertainty. The downgrade was more a psychological blow than a fundamental shift in creditworthiness.
In 2023, Fitch’s downgrade triggered a more muted response. Markets had become somewhat desensitized to political brinkmanship over the debt ceiling. Stocks dipped, bond yields rose slightly, but the broader economic narrative remained intact.
Now in 2025, Moody’s downgrade has again rattled markets. Futures fell, bond yields ticked higher, and investors are reassessing risk2. But as with past downgrades, the long-term impact may be less severe than the initial headlines suggest.
Implications for Long-Term Interest Rates
A downgrade signals increased risk, prompting investors to demand higher yields on government debt. This raises long-term interest rates, particularly on 10- and 30-year Treasuries. Higher yields can ripple through the economy, affecting everything from corporate borrowing to consumer loans.
The 10-year Treasury yield rose to 4.48% in after-hours trading following the downgrade1. While this may seem modest, even small increases in long-term rates can significantly raise the cost of capital across the economy. As discussed in our January 10th blog post, What Lies Beneath, our debt and debt service obligations continue to be one of the major risk factors we are concerned about as higher rates can become the “U.S. exceptionalism” theme’s Achilles heal.
Higher Borrowing Costs for Consumers and Companies
As Treasury yields rise, so do mortgage rates. A 30-year fixed mortgage that was once 6.5% could climb above 7%, pricing out many would-be homebuyers. This slows the housing market, reduces construction activity, and dampens consumer spending.
For businesses, higher borrowing costs could mean reduced investment. Companies may delay expansion, hiring, or innovation due to more expensive debt. Small and mid-sized firms, which rely more heavily on loans, are particularly vulnerable.
The Government’s Debt Spiral
Perhaps the most concerning consequence is the impact on the federal government itself. The U.S. is already running a deficit exceeding $1 trillion annually1. As interest rates rise, the cost of servicing that debt balloons. In fiscal terms, this is known as the “cost to carry.”
Higher interest payments crowd out other spending—on infrastructure, defense, or social programs—and make it harder to reduce the deficit. This creates a vicious cycle: more debt leads to higher interest payments, which leads to more borrowing, and so on.
Moody’s cited this dynamic explicitly, warning that without structural reforms, the U.S. faces a long-term erosion of fiscal credibility1. As you can see in the graphic below, the U.S. is already in the top 10 in terms of Debt-to-GDP ratio (123%) worldwide and we rank as the 3rd highest of the G7 countries behind #1, Japan 235% and #2, Italy 137% (the others in order are #4, France 116%, #5, Canada 113%, #6 UK 104% and #7 Germany 65%).
The Dollar’s Role as Global Reserve Currency
The downgrade also raises questions about the U.S. dollar’s role as the world’s primary trade and reserve currency. While the dollar remains dominant, persistent fiscal mismanagement and political dysfunction erode confidence.
Countries like China and Russia have already begun diversifying away from the dollar. If this trend accelerates, demand for U.S. assets could weaken, further pressuring interest rates and the exchange rate. A weaker dollar makes imports more expensive, fueling inflation.
However, no viable alternative to the dollar has yet emerged. The eurozone faces its own challenges, and China’s yuan lacks full convertibility. For now, the dollar’s status is dented—but not dethroned.
A Look Back: Recovery After Previous Downgrades
Despite the gloom, history offers hope. After the 2011 downgrade, the S&P 500 eventually rebounded and entered a multi-year bull market. The economy continued to grow, and Treasuries remained the world’s most trusted safe-haven asset.
Similarly, after Fitch’s 2023 downgrade, markets stabilized within weeks. Investors recognized that while the downgrade was symbolic, the U.S. still had unmatched economic scale, innovation, and institutional strength. The markets went through a digestion phase before eventually breaking to new highs in approximately two and half months (see action of the Nasdaq 100 - Invesco QQQ Trust below):
The same may hold true in 2025. While the downgrade is a wake-up call, it does not signal imminent collapse. If anything, it underscores the need for fiscal reform and long-term planning.
Conclusion
Moody’s downgrade of U.S. Treasuries is a significant event, but not an unprecedented one. It reflects real concerns about debt, deficits, and political gridlock. Yet markets are resilient. History shows that after the initial shock, investors recalibrate, and growth can resume.
The path forward will depend on how policymakers respond. Will they address the structural drivers of debt, or continue to kick the can down the road? The current administration is still on a path that not only ignores our current debt issues but will add an additional $2.5 trillion to the federal debt over the next decade.4 History has shown that the U.S. economy can weather these storms—and emerge stronger.
If you have any questions or concerns, please reach out.
Warm Regards,
JOSH J. MILES, CPWA®, BFATM
Managing Director
Private Wealth Advisor
Financial Advisor
Sources:
2. sharecafe.com: https://www.sharecafe.com.au/2025/05/19/moodys-downgrade-sparks-market-jitters-as-us-credit-rating-slips-to-aa1/
3. Chart 1. QQQ – Invesco Nasdaq 100 ETF. Historical returns from MarketSurge chart service.
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