Fitch Downgrade Lays Out Bear Case for Longer-Dated Treasuries

Fitch Ratings’ decision to strip the US of its AAA credit ranking this week highlights the booming deficits that are at the heart of the bear case for Treasuries, even as some investors remain bullish.

(Bloomberg) — Fitch Ratings’ decision to strip the US of its AAA credit ranking this week highlights the booming deficits that are at the heart of the bear case for Treasuries, even as some investors remain bullish. 

The downgrade elicited a much calmer response than the panic-tinged rally that took place 12 years ago when S&P Global Ratings lowered its US grading. Treasury 10-year yields have edged up about seven basis points since the Fitch announcement late Tuesday, versus a 24 basis-point slide on Aug. 8, 2011, when investors ended up buying US debt as a haven when global markets were rocked by the S&P cut.

Treasuries were already languishing this year, disappointing investors who had anticipated a rally once Federal Reserve interest-rate hikes pushed the economy toward recession. With economic data instead remaining relatively robust, Fitch’s decision put the focus squarely on the boom in US government borrowing at a time yields are already near multi-decade highs.

“With $32 trillion of debt and large deficits as far as the eye can see and higher refi rates, an increasing supply” of Treasuries is assured, Bill Ackman, founder of Pershing Square Capital Management, wrote Wednesday in a post on X, the platform formerly known as Twitter. “It is hard to imagine how the market absorbs such a large increase in supply without materially higher rates.”

Ackman said he’s placing sizable bets on declines in 30-year Treasuries, both as a hedge against rising stocks, and also because there’s a strong case for yields to keep going higher. Yields are also likely to rise due to the Fed’s plans to carry out quantitative tightening by reducing the $8.2 trillion balance sheet it built up through buying Treasuries and mortgage-backed debt, he said.

Returns from the two ends of the US yield curve are diverging. Longer-term Treasuries have dropped 1% this year, compared with a 0.5% gain for a broader gauge of US debt, according to Bloomberg indexes.

Fitch Ratings still expects a US recession, putting it odds with the Fed and a growing proportion of analysts who predict the central bank will succeed in taming inflation and engineer a soft-landing. 

This week’s downgrade was based on the medium-term fiscal outlook, “which is characterized by rising deficits and government debt,” said James McCormack, global head of sovereign and supranational ratings for Fitch in Hong Kong.

‘Critical Level’

Treasury 30-year yields climbed to 4.21% on Thursday after 10-year yields reached 4.12% the day before, both the highest levels this year.

US yields are “at a critical level,” said Khoon Goh, head of Asia research at Australia & New Zealand Banking Group Ltd. in Singapore. “If 4.1% were to break, then the next major 10-year level we’ll be looking at will be around 4.35 or 4.4%.” 

There’s been something of a pattern in the Treasury market this year, with investors piling in every time yields jumped, as cooler inflation readings trimmed bets on Fed rate hikes. Yields may still end up being capped despite the Fitch downgrade, according to money manager GSFM.

Fitch’s move will focus investors on the deterioration in the US fiscal position, but that’s probably already priced in, according to Stephen Miller, an investment strategist at GSFM in Sydney. 

“I don’t think it is likely that yields go much higher from here, and if they do then I think I would be buying them,” he said. “The more important dynamic is that the Fed has the measure of inflation.”

Repricing Risk

For his part, Pershing Square’s Ackman said part of the attraction for shorting longer-maturity US debt is that it acts as a hedge against the potential that higher long-term yields will hurt stocks.

There’s a potential for 30-year yields to rise toward 5.5%, and it could “happen soon,” he said. “There are many times in history where the bond market reprices the long end of the curve in a matter of weeks, and this seems like one of those times.”

–With assistance from Ruth Carson.

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