DBRS, Inc. (DBRS Morningstar) confirmed the United States of America’s Long-Term Foreign and Local Currency – Issuer Ratings at AAA. At the same time, DBRS Morningstar confirmed the United States of America’s Short-term Foreign and Local Currency – Issuer Ratings at R-1 (high). The trend on all ratings is Stable.
KEY CREDIT RATING CONSIDERATIONS
The Stable trend reflects DBRS Morningstar’s view that the strength of the U.S. economy, its public institutions and financial markets continue to provide support to the AAA rating. The U.S. economy is exceptionally large, accounting for one-quarter of global output, and highly resilient given its diversification, flexible labor markets, and innovative and competitive private sector. The country benefits from well-established democratic institutions, a strong legal system, and transparent governance. In addition, U.S. financial markets and the U.S. dollar are at the center of world trade and capital flows, which provides the U.S. with an unusually high degree of financing flexibility.
Notwithstanding these credit strengths, two interrelated challenges could impact U.S. credit fundamentals over time. First, the federal fiscal deficit is projected to hover around 5-6% of GDP from 2023 to 2030, according to the Congressional Budget Office (CBO). Unless the government addresses its sizable structural deficit, public debt metrics will continue deteriorating over the medium term, potentially damaging the country’s economic prospects and resilience to shocks. Second, heightened political polarization may complicate efforts to implement reforms needed to address the country’s growing public finance challenges.
CREDIT RATING DRIVERS
The ratings could be downgraded due to one or a combination of the following factors: (1) a failure to reduce projected fiscal deficits over the medium term, (2) a material deterioration in economic and financial resilience, or (3) a failure by Congress to lift the debt ceiling thereby forcing the Treasury to materially delay non-debt payments.
CREDIT RATING RATIONALE
The Economy Continues To Show Resilience In Spite Of Tighter Monetary Policy
DBRS Morningstar holds a positive view on the fundamental strengths of the U.S. economy. The U.S. is the largest economy in the world, highly diversified, and resilient to shocks. The U.S. is a global leader in innovation and research. Moreover, economy-wide productivity levels are elevated compared to other advanced economies. These factors lend support to the Economic Structure and Performance building block assessment. It is also worth noting that there are few signs of economic scarring in the aftermath of the COVID-19 shock: real GDP is broadly in line with its pre-pandemic trend and labor force participation has recovered even as the unemployment rate is running at a historically low level.
Economic activity continued to grow at a solid pace in the first half of 2023, although there are some signs that the economy is starting to lose momentum. Output increased 2.2% (q/q) annualized in the first quarter and 2.1% (q/q) in the second quarter. The primary driver of growth is personal consumption. Households are benefiting from healthy balance sheets and a strong labor market. Despite higher interest rates, household debt-servicing payments as a share of disposable income is near a 50 year low. The labor market continues to be tight but there are some signs of cooling. The quits rate, for example, has returned to its pre-pandemic level, which indicates that employed workers may be becoming less confident in their ability to find jobs elsewhere, and the average number of hours worked per week has steadily declined, which could indicate that employers are now fully staffed and/or reducing hours amid weakening demand.
Looking ahead, DBRS Morningstar expects the economy will run close to stall speed for the next 2-3 quarters before accelerating modestly in the second half of 2024. Consumers will likely become more discerning in their spending choices amid higher borrowing rates, the resumption of federal student loan repayments in October 2023, and rising energy costs. Demand components that are more sensitive to interest rates, specifically goods consumption and residential investment, will also continue to face headwinds as they adjust to tighter policy settings.
External Accounts Reflect Dollar Strength And Safe Haven Flows
The U.S. current account deficit widened in the wake of the COVID-19 pandemic. From 2019 to 2022, the deficit increased from 2.1% of GDP to 3.8%. Most of the deterioration stems from strong import growth as the U.S. economy rapidly recovered from the shock of the pandemic and consumption patterns shifted toward tradable goods. Primary income receipts (driven by returns on foreign assets) also did not recover as strongly as primary income payments (returns on U.S. assets held by foreigners), and remittance payments abroad increased markedly. With the economy slowing, weaker import demand helped narrow the current account deficit in the first half of 2023 and we expect this trend to continue in 2024.
In spite of the strong dollar, the net international investment improved in 2022. International assets and liabilities declined due to the global equity market downturn, but the latter declined by more. The drop in external liabilities also reflected foreign central banks (particularly China and Japan) selling a portion of their holdings of U.S. Treasuries to intervene in FX markets in support of their own currencies. DBRS Morningstar views U.S. external accounts as benefiting from the unique role and position of the U.S. dollar within international finance. This limits risks and lends support to the Balance of Payments building block assessment.
The Strength Of The Economy May Require Monetary Policy To Be Tighter For Longer
The inflation outlook has clearly improved but returning to the two percent target could require high rates for longer. Annual inflation declined from its peak of 9.1% in June 2022 to 3.0% in June 2023. Two months later, headline inflation inched back up to 3.7%, but this was largely due to the recent rise in energy prices. Core CPI (3 month annualized) continued to moderate and reached 2.4% in August. The disinflation trend will continue to be supported by easing shelter prices. Shelter inflation has turned a corner as the lagged effects of a cooler housing market are now leading to lower inflation in both tenant and owners’ equivalent rent. This dynamic is set to continue through the end of 2023. Nevertheless, offsetting forces, including rising global energy prices and the ongoing strength of the labor market, could put upward pressure on prices and slow inflation’s return to two percent.
To quell inflationary pressures, the Federal Reserve has hiked the federal funds rate by 525 bps in the last 19 months, taking the policy rate to 5.25%-5.5%. The Federal Funds rate appears to be at or close to its peak, although the Fed looks set to maintain a tight policy stance for a prolonged period. According to the latest Summary of Economic Projections, the median forecast for the Federal Funds rate is 5.0%-5.25% at the end of 2024, even as the median PCE inflation is forecast to decline to 2.5%. In DBRS Morningstar’s assessment, the Fed’s actions demonstrate its resolve to bring inflation back down to the target. Although restrictive monetary policy settings pose near-term risks of a recession, these actions reinforce the credibility of the Fed in preserving price stability.
The rapid rise in interest rates is putting stress on some parts of the banking system. Bank deposits have been declining since the second quarter of 2022 as customers have sought higher yielding assets. This has primarily benefited money markets. In the first quarter of 2023, when there were significant deposit outflows and several bank failures, U.S. regulators reacted aggressively to calm financial markets. By the following quarter, the pace of deposit outflows had slowed and financial markets had stabilized. In addition to higher funding costs, low-yielding fixed-rate assets and normalizing asset quality are headwinds to earnings. Small- and medium-sized banks with high commercial real estate exposure, particularly office space, could face greater challenges.
Nevertheless, the banking system as a whole looks relatively well-positioned to navigate potential market turbulence. Net interest margins exceed pre-pandemic levels, despite higher funding costs, and non-performing loans remain at historically low levels. U.S. commercial banks posted Tier 1 capital in Q1 2023 at 14.1% of risk-weighted assets, which is above prepandemic levels. Moreover, many banks are retaining earnings in order to meet new capital requirements. These factors lend support to the Monetary Policy and Financial Stability building block assessment.
The Absence Of A Strategy To Put Fiscal Accounts On A Sustainable Path Could Weaken U.S. Creditworthiness Over The Medium Term
The medium-term fiscal outlook is a source of concern. The Congressional Budget Office (CBO) projects the federal deficit to hover around 5-6% of GDP from 2023 to 2030 (including the effects of the Fiscal Responsibility Act of 2023). Given the cyclical strength of the economy, the deficit reflects a structural imbalance. Moreover, DBRS Morningstar believes that the risks to the outlook are skewed to the downside. The fiscal results could deteriorate more quickly if part or all of the 2017 tax cuts are extended, the growth in defense spending outpaces expectations, or interest costs increase more than anticipated.
Federal debt held by the public is expected to rise from 97% of GDP in 2022 to 104% in 2027, and then rise quickly thereafter. If policymakers are unwilling or unable to address the government’s sizable and growing fiscal imbalance, public debt metrics will continue to deteriorate over the medium term, potentially damaging the country’s growth prospects and resilience to shocks. At the moment, however, the political appetite for fiscal reform appears limited.
The U.S. Maintains a High Degree of Financing Flexibility
In spite of poor fiscal outcomes at the federal level, the U.S. retains an unusually high degree of flexibility in financing its debt. The resilience of the U.S. Treasury market, which is supported by the use of the dollar as the world’s primary reserve currency, continues to lend support to the Debt & Liquidity building block assessment. Demand for Treasury securities is consistently strong, coming from a wide range of banks, official sector buyers, and other investors in need of highly liquid assets. In spite of recent sales of USD assets by a few major foreign central banks for FX intervention purposes, official holdings account for roughly one-third of outstanding debt of the public sector. The durable funding advantage provides the U.S. government with a higher capacity to finance debt and to carry a relatively high debt burden without harming growth prospects.
Political Polarization Could Make It More Difficult To Address Key Credit Challenges
U.S. political institutions are highly open and transparent, providing a high degree of public accountability and strong incentives for sound governance. Changes to federal law, including the budget, must be approved by three separate bodies: the House, the Senate and the Presidency, which respond to different constituencies and are frequently controlled by different parties. As a result, legislative negotiations are often challenging, and delays are in large part a feature of the United States’ pluralistic and competitive presidential system.
Increased polarization is nonetheless a challenge. With low levels of trust between the two main parties and a deeply divided electorate, polarization appears to have weakened centrist politics and strengthened extreme posturing. Both parties have displayed an unwillingness to compromise due to the diverging priorities of their respective party base. With control of congress currently split between Democrats and Republicans, the highly polarized political environment reduces the likelihood that Congress will enact reforms needed to address the country’s key credit challenges.
ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS
There were no Environmental, Social, or Governance factors that had a relevant or significant effect on the credit analysis.
A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (July 4, 2023) at https://www.dbrsmorningstar.com/research/416784/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings.
For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments at: https://www.dbrsmorningstar.com/research/421627.
All figures are in USD unless otherwise noted. Public finance statistics reported on a general government basis unless specified.
The principal methodology is the Global Methodology for Rating Sovereign Governments (August 29, 2022) https://www.dbrsmorningstar.com/research/401817/global-methodology-for-rating-sovereign-governments-archived. In addition DBRS Morningstar uses the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings https://www.dbrsmorningstar.com/research/416784/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings in its consideration of ESG factors.
The credit rating methodologies used in the analysis of this transaction can be found at: https://www.dbrsmorningstar.com/about/methodologies.
The conditions that lead to the assignment of a Negative or Positive trend are generally resolved within a 12-month period. DBRS Morningstar’s outlooks and credit ratings are monitored.
The primary sources of information used for this credit rating include the U.S. Department of Treasury, Federal Reserve Board, Congressional Budget Office, Office of Management and Budget, Bureau of Economic Analysis, Bureau of Labor Statistics, Bank for International Settlements, International Monetary Fund, World Bank, S&P Corelogic, and Haver Analytics. DBRS Morningstar considers the information available to it for the purposes of providing this credit rating was of satisfactory quality.
The credit rating was not initiated at the request of the rated entity.
The rated entity or its related entities did not participate in the credit rating process for this credit rating action.
DBRS Morningstar did not have access to the accounts, management and other relevant internal documents of the rated entity or its related entities in connection with this credit rating action.
This is an unsolicited credit rating.
This credit rating is endorsed by DBRS Ratings Limited for use in the United Kingdom, and by DBRS Ratings GmbH for use in the European Union, respectively. The following additional regulatory disclosures apply to endorsed credit ratings:
The last credit rating action on this issuer took place on July 28, 2023.
With respect to FCA and ESMA regulations in the United Kingdom and European Union, respectively, this is an unsolicited credit rating. This credit rating was not initiated at the request of the issuer.
With Rated Entity or Related Third Party Participation: NO
With Access to Internal Documents: NO
With Access to Management: NO
For further information on DBRS Morningstar historical default rates published by the European Securities and Markets Authority (ESMA) in a central repository, see: https://registers.esma.europa.eu/cerep-publication. For further information on DBRS Morningstar historical default rates published by the Financial Conduct Authority (FCA) in a central repository, see https://data.fca.org.uk/#/ceres/craStats.
Lead Analyst: Michael Heydt, Senior Vice President, Global Sovereign Ratings
Rating Committee Chair: Nichola James, Managing Director, Global Sovereign Ratings
Initial Rating Date: September 8, 2011
For more information on this credit or on this industry, visit www.dbrsmorningstar.com.
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