Key Highlights

• The Moody’s downgrade is not a game changer, but does highlight fiscal risks
• While foreign bond-buying has generally resumed, the 7-10y part of the curve remains under pressure
• 7-10y cross-border demand wanes during recent risk-off episodes

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Downgrade not a game changer, but fiscal risks are important

EXHIBIT #1: INTEREST COSTS SOAR

_{Source: BNY Markets, Bureau of Economic Analysis}

This weekend’s downgrade by Moody’s of the U.S. sovereign credit rating is not a game changer. In many ways, it was actually a long time coming, with the ratings agency having put the U.S. on negative watch back in November 2023. The other two main agencies moved much earlier in lowering the U.S.’s top-notch rating – S&P in 2011 and Fitch in 2023. The state of U.S. fiscal accounts has been apparent for some time, and the math is clear. That this ratings downgrade comes as little surprise, then, is understandable, and the market response has been relatively muted, with some initial increases in yields at the back end of the curve, a slightly weaker U.S. dollar and slightly softer equities.

One of the reasons for the downgrade was the rising interest costs for government debt, due to both higher interest rate charges on new debt issued and the presence and preponderance of fiscal deficits and ever-growing debt. This set of circumstances can lead to a vicious cycle, with higher deficits requiring more borrowing at higher interest rates, which exacerbates the debt and requires even more borrowing at even higher rates to pay the existing debt.

Interest expenses now account for around $1tn, or 3.7% of GDP. Note that the 2024 U.S. federal budget deficit was 4.3% of GDP, or about $6.8tn, an extraordinarily large shortfall for an economy that was close to full employment last year. Exhibit #1 shows the growth of this interest expense since 1950. As a percentage of GDP it was higher in the 1980s when the U.S. was facing large structural deficits and extremely high interest rates.

Market reaction has been relatively muted, and confirms the view expressed above that this downgrade is neither a surprise nor a major revelation. However, we still – and have expressed this point many times recently – fear that the current environment, with tepid foreign demand for U.S. Treasurys, a hot trade war and a large fiscal package still being crafted in Washington that will likely add to the deficit, could see a continuation of the grind higher in U.S. Treasury yields, with the 10y note now trading near 4.5%.

Forward look

We still think yields can grind higher, and the implications of sustained 10y yields above 4.5% for a period of time matter. Leveraged corners of the markets (private equity and credit, for example), risk asset valuations, and even household and corporate finances are highly leveraged to interest rates, and this could be something to watch as we head deeper into 2025.

Foreign bond demand recovers; but 7-10y notes still seeing selling

EXHIBIT #2: MIXED CROSS-BORDER SELLING AND BUYING ACROSS THE CURVE

_{Source: BNY Markets, iFlow}

We wrote a lot about cross-border selling of US Treasurys in April when there was elevated market volatility. A few weeks ago, after markets had settled down somewhat, we pointed out that widespread and intense selling had slowed and there was some respite in the “sell USTs” trade by foreign-domiciled investors (see here).

This remains the case, with some exceptions. In particular, the 7-10y segment continues to see outflows and hasn’t really recovered from its April swoon. The 10+ year segment continues to see strong inflows, and this is likely related to inelastic buying on the very long end of the curve, as insurance companies, pension funds and other long duration liability hedgers are fairly inelastic buyers. See Exhibit #2, which shows flows into the curve at different maturities, including cash and other short-term assets (CAST). Note the deep selling of the 7-10y segment, which is shown as an average over the last 20 trading days. 

EXHIBIT #3: TERM PREMIUM NOT HIGH ENOUGH TO BUY

_{Source: BNY Markets, iFlow}

In Exhibit #3, we can see the behavior of foreign flows over the last 11 months. Typically, the 7-10y segment has featured more selling by cross-border investors than the overall market. The highlighted section shows the divergence between total bond flows from abroad and just those in that long/intermediate section of the curve.

Furthermore, note the periods of heavy 7-10y selling on the chart: early August 2024 (summer VAR shock), late-January through early-February 2025 (10y yields reached 4.8% on January 16) and the period from April to now. We have in the past commented that 10y notes were not exhibiting expected safe-haven behavior during these risk events, and this chart demonstrates that while we saw selling pressure during risk events, we did not see cross-border investors fleeing to the safety of the 10y note. 

Forward look

This is simply more evidence that we are currently operating in a period during which these Treasury instruments are not perceived as riskless, or at least not as useful in buffering risk-off events in the markets as before. The U.S. rating downgrade won’t help, and even though Moody’s hasn’t done more than simply describe current fiscal dynamics, it’s getting harder to ignore the fact that something has changed – at least for now – in the Treasury market amongst cross-border investors.

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