Muzinich Weekly Market Comment: Debt Spiral?

May 27, 2025

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In our latest roundup of the key developments in financial markets and economies, we discuss the implications of the recent credit rating downgrade of the United States from AAA .

The main market mover for investors last week came from the headline that the US sovereign lost its official AAA credit rating, after Moody’s joined the two other major rating agencies in downgrading it to AA+.¹ This downgrade leaves the AAA-rated club even more exclusive, now consisting of just eleven countries: Germany, Switzerland, the Netherlands, Canada, Australia, Singapore, Denmark, Sweden, Norway, Luxembourg, and Liechtenstein.²

Should investors be concerned? Not necessarily. According to S&P’s rating definitions, an obligation rated ‘AA’ differs from the top-tier ‘AAA’ rating only to a small degree.³ The process of establishing a credit rating is primarily focused on the relative likelihood of default. That is, issuers are ranked based on their ability to withstand increasingly extreme economic stress scenarios.

An ‘AAA’ rating implies that an obligor is expected to endure extreme stress without defaulting. In contrast, an ‘AA’ rating reflects an ability to withstand severe stress and still meet financial obligations. According to S&P, a severe stress scenario would involve a 15% decline in GDP, 20% rise in unemployment, and up to a 70% drop in the domestic stock market.³

To put things into perspective, both the Global Financial Crisis (GFC) and the COVID-19 pandemic were classified as BBB-level stress environments. For the US, there have been only two recorded AAA-level stress events since records began in 1797: the Railroad Panic of 1857, and the Great Depression of 1929.³ So, unless one expects the US economy to collapse into a depression, the US sovereign debt is fundamentally sound, in other words, “money good.”

Assessing creditworthiness

In building their credit models to assess the robustness of a sovereign and mapping it to the appropriate stress scenario (or rating bucket), analysts focus on three critical areas: economic strength, institutional strength, and fiscal strength.

The United States' economic strength is unquestionable. A flexible labor market, strong productivity growth driven by technological innovation, effective macroeconomic policy, and the unique advantage of the US dollar’s reserve currency status have, together, contributed to a growth rate that has significantly outpaced many other high-income and AAA-rated countries.⁴

Likewise, from an institutional perspective, the United States is underpinned by strong and independent institutions, with a long-standing commitment to the rule of law, constitutional separation of powers, and high levels of transparency. However, in recent years, increasing political polarization, most notably illustrated by repeated congressional brinkmanship over the debt ceiling, has fueled concerns that the legislative and executive branches are unlikely to implement the substantial policy shifts needed to address mounting fiscal pressures. This has made fiscal strength the central concern for credit rating agencies and the key factor behind the loss of the US AAA rating. In its downgrade report, Moody’s assigned the US a fiscal strength score of Ba2 (equivalent to BB), citing a deterioration in fiscal metrics driven by a rising debt burden and declining debt affordability.⁴

Since the GFC, cumulative fiscal deficits have driven outstanding US federal government debt significantly higher. At the end of the 2007 fiscal year, US debt stood at US$9 trillion, or 62% of GDP. By the end of fiscal year 2024, that figure had more than tripled to US$34.5 trillion, pushing the debt-to-GDP ratio to 121% (See ‘Chart of the week’), the highest among all AAA and AA rated sovereigns. We note that under the US federal debt figures, intragovernmental holdings (such as trust fund balances) are included, whereas internationally standardized measures of government debt, known as “general government measures,” exclude these internal obligations and consolidate across federal, state, and local levels. Under these internationally comparable measures, the US debt-to-GDP ratio rose from 35.2% in 2007 to 97.8% in 2024.⁵

Furthermore, as interest rates rise and the amount of debt increases, debt affordability could deteriorate. This is reflected in rising interest payments which, if unaddressed, could undermine a sovereign's long-term growth potential, as an ever-growing share of the government’s revenue is consumed by debt servicing. By comparison, at the general government level, US interest payments amounted to 12% of total revenue in 2024, compared to a median ratio of just 1.6% among AAA-rated sovereigns.⁴

How to break the cycle

Should we be concerned that US debt is becoming unsustainable? Rising government debt, which usually drives up interest rates, could result in higher debt servicing costs that could crowd out productive investment. This might result in slower growth that threatens to erode tax revenues, prompting even more borrowing. We may be looking at a vicious cycle heading toward a potential debt spiral.

To break the cycle, or at least stabilize the debt at current levels, we believe the US government must ensure that nominal economic growth exceeds the effective interest rate on its debt, while also narrowing the primary deficit (the gap between revenue and non-interest spending). The current administration has addressed this challenge in its economic plan by targeting 3% annual real GDP growth through the extension of the Trump-era Tax Cuts and Jobs Act and deregulating the banking sector to boost lending. The administration also aims to reduce the fiscal deficit to around 3% of GDP - roughly achieving a primary fiscal balance - through spending cuts, supported by initiatives such as the Department of Government Efficiency (DOGE), and by increasing revenue through its international tariff program.⁶

Although we are still early in the administration's term, initial signs are mixed. In its March economic projections, the Federal Reserve forecast real GDP growth of 1.7% in 2025, with long-term potential growth estimated at 1.8%.⁷ Furthermore, since the launch of the ‘Liberation Day’ Tariff Initiative, the Committee has warned that risks are skewed towards even weaker growth in the near term.

On the fiscal front last week, the House of Representatives narrowly passed the administration’s tax bill in a 215–214 vote, with one abstention. After factoring in new tariff revenues and DOGE-related spending cuts, the fiscal deficit is expected to remain broadly flat between 2025 and 2026. However, it would remain elevated at around 6% of GDP. ^8&8a Moody’s remains pessimistic - in its accompanying report following the downgrade, the agency’s baseline scenario projects general government debt to rise to approximately 130% of GDP by 2035.⁹

The rising trend of US sovereign debt is unmistakable, though the trajectory remains gradual. This growing indebtedness is largely driven by structural factors: a demographic shift toward an aging population and rapidly rising healthcare costs—now the highest in the world. Healthcare alone accounts for nearly one-fifth of the nation’s total economic output and is among the fastest-growing components of the federal budget.⁶

At its core, the challenge is straightforward. The US must find sustainable ways to bridge the gap between government revenues and the spending commitments made by policymakers. Encouragingly, the current administration is making efforts to address the issue through innovative, unconventional measures, including the creation of the DOGE and tariff initiatives aimed at correcting long-standing global competitive imbalances.

Time is on the sovereign’s side

Time remains on the sovereign’s side. We believe the recent credit rating downgrade to AA should be viewed as an early warning rather than a sign of imminent crisis. The US remains solvent under all but the most extreme, once-in-a-century scenarios. Moreover, the US dollar's status as the world’s reserve currency provides a significant advantage, enabling both a higher capacity for debt issuance and access to low-cost funding.

However, it is imperative that the government presents a united front. Fiscal complacency - or worse, excessive largesse - could rapidly erode investor confidence. A cautionary example can be seen in Brazil’s recent experience, where fiscal mismanagement led to a severe currency depreciation, an emergency 425-basis-point hike in central bank policy rates¹⁰, and a dramatic collapse in government popularity.

Last week, the effects of rising concerns rippled through US capital markets: the US Treasury yield curve bear-steepened, the dollar weakened, spreads widened in US high-yield credit markets, and equity markets declined, underperforming global peers. Furthermore, as the issuer of the world’s reserve currency, the US plays a central role in setting the global risk-free rate. As risk premiums rise, the contagion effect starts to become more evident with major global markets mirroring movements in US asset prices. For those considering the ultimate negative tail risk, an accelerating US debt spiral should be at the top of the list.

Chart of the Week: Is the US in the early stages of a debt spiral? ⁵

Source: FiscalData as of March 31, 2025. For illustrative purposes only. Reference to $ is to US Dollars.

References

1. Moody’s Ratings as of May 16, 2025.
2. S&P Global ratings as of April 28, 2025.
3. S&P Global Ratings Definitions as of December 2, 2024.
4. Moody’s Ratings as of May 19, 2025.
5. Peter G. Peterson Foundation and Congressional Budget Offices as of December 2024.
6. Fox Business ‘Treasury secretary nominee Scott Bessent's '3-3-3' plan: What to know’ as of November 25, 2024.
7. Board of Governors of the Federal Reserve System: FOMC Projections materials, accessible version as of March 19, 2025.
8 & 8a. Citi ‘ US Economics The Daily Update and Bloomberg ‘ Trump Tax Bill Narrowly Passes House, Overcoming Infighting’ as of May 22, 2025.
9. Moody’s Ratings as of March 25, 2025.
10. Bloomberg as of May 22, 2025. Brazil Selic Target Rate (BZSTSETA) Index.

 

This material is not intended to be relied upon as a forecast, research, or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed by Muzinich & Co. are as of May 23, 2025, and may change without notice. All data figures are from Bloomberg, as of May 23, 2025, unless otherwise stated.

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Index Definitions:

Brazil Selic Target Rate (BZSTSETA) Index: A target interest rate set by the central bank in its efforts to influence short-term interest rates as part of its monetary policy strategy.

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