Macro Signposts | 21 May 2025
Moody's Downgrade Underscores Tensions Over U.S. Debt Outlook
I'd like to thank Libby Cantrill, PIMCO's head of public policy, and economists Allison Boxer and Graeme Westwood for their contributions to this edition.
Following the Moody's downgrade last week, U.S. sovereign debt no longer holds a top-tier credit rating from any of the three major rating agencies. Though it led to a flurry of news headlines over the weekend, the downgrade didn't reveal much new information. Rather, it confirmed that the U.S. has been and remains on an unsustainable fiscal path, which we believe is likely to get marginally worse under the Trump administration.
Moody's noted how the U.S. fiscal position and outlook have deteriorated, while government leaders lack the political will to address the situation. While these fiscal challenges are widely known, we interpret last week's downgrade as a warning to policymakers currently negotiating a large tax and spending bill. While the details of the tax bill - as well as the outlook for tariff revenue - remain uncertain, it seems clear to us that meaningful fiscal consolidation isn't likely under this administration - just as it was unlikely under the past several administrations. The combination of the Trump administration's desire to cut taxes in line with campaign proposals and a slim Republican majority preventing meaningful spending reforms is likely to keep the U.S. deficit - at best - moving sideways at roughly double its pre-pandemic level for the foreseeable future.
Over the long run, deficits of this magnitude, together with rising interest expense and increasingly costly social safety net programs, mean that current U.S. fiscal policy is unsustainable - but it has been unsustainable for years. The U.S. also stands out relative to most other developed countries (Japan and France are exceptions) for having a high and rising debt burden. But the U.S.' status as the issuer of the global reserve currency, its still manageable debt-to-wealth ratio, and a lower current tax burden (as a percentage of GDP) relative to other developed market economies provides some fiscal flexibility - suggesting that a U.S. fiscal problem doesn't need to become a U.S. debt crisis.
For investors, the U.S. debt trajectory does argue for a steeper U.S. interest rate curve and higher term premiums (i.e., compensation that bond investors earn for taking on interest rate risk) over time. It also argues for a closer look at opportunities in global fixed income.
U.S. fiscal challenges are nothing new
The combination of an aging society, high and rising healthcare costs, and social safety net programs has led to projections of U.S. debt-to-GDP levels accelerating higher in the coming years, according to the U.S. Congressional Budget Office (CBO). These projections have been a lasting feature of the post-financial-crisis economic landscape, contributing to both the Tea Party political movement and the bipartisan Simpson-Bowles commission to study fiscal reforms during the Obama administration. However, political polarization has challenged even bipartisan plans to implement politically painful adjustments to mandatory spending programs.
The pandemic exacerbated the problem, as large stimulus packages in 2020 and 2021 significantly increased the stock of government debt. Since then, deficits relative to GDP have remained wider than they were on average in the five years before the pandemic, and interest costs have risen.
The U.S. is not alone in facing a tough fiscal trajectory: The public sector has borne the brunt of post-pandemic financial strain, worsening government debt sustainability in many developed economies. However, relative to most of its peers, the U.S. debt ratio is likely to continue to rise sharply over the secular horizon.
That said, the U.S. also has a notable degree of fiscal flexibility. Despite some marginal diversification away from the still U.S.-dollar-dominated system for global transactions and away from dollar dominance within foreign reserve portfolios, the U.S. Treasury market remains the deepest, most liquid sovereign bond market in the world. The U.S.' relatively low tax collections as a percentage of GDP relative to its peers, along with its manageable debt-to-wealth ratio, should also contribute to confidence that the U.S. economy has room to maneuver. (Learn more in PIMCO's July 2024 article, "Developed Market Public Debt: Risks and Realities.") Greater U.S. labor mobility, a culture of innovation, and a lighter regulatory touch - especially in frontier technology fields - have also contributed to the U.S.' generally better productivity and growth performance.
As Moody's downgrade suggested, this state of fiscal privilege hinders the political will to confront the established programs - in particular, long-term social safety net programs such as Social Security and Medicare - that place the U.S. on unsustainable footing. In the 2030s, however, as funding for these programs likely reaches a tipping point, policymakers may be forced to act. They may also respond to the discomfort of seeing debt interest payments nearly matching defense spending - a threshold that coincided with fiscal consolidation in the 1990s.
Any reforms would likely need bipartisan support, and previous bipartisan commissions have created blueprints that, if implemented, could make strides in that direction. However, a more polarized political environment has made implementing even bipartisan reforms difficult.
Tax legislation and tariff revenue unlikely to drive meaningful fiscal improvement
There is widespread agreement that meaningful fiscal consolidation, including reform of Social Security and Medicare, is necessary at some point. There is also widespread agreement that the Trump administration and Congress aren't likely to drive those reforms, and if anything, the 2025 tax and spending legislation could further challenge the outlook (similar to deficit-financed fiscal expansion policies under other recent administrations).
The tax bill currently under consideration in Congress is a sweeping package that extends and expands many provisions from the 2017 Tax Cuts and Jobs Act (TCJA), including making individual tax cuts permanent, increasing the standard deduction, expanding the Child Tax Credit, and raising the state and local tax (SALT) deduction cap. Extending these provisions is estimated to add more than $4 trillion to U.S. debt over the next 10 years, relative to the alternative of not extending them, according to the CBO.
What is worse for the debt outlook is that the bill also introduces new tax deductions for tips, overtime pay, senior taxpayers, and auto loan interest, while providing significant business tax breaks such as extended R&D expensing and bonus depreciation. On the spending side, lawmakers are aiming to pay for some of the additional tax breaks through more substantial cuts to the Medicaid program, along with other cuts. However, as currently written, the bill's front-loaded tax cuts and back-loaded spending cuts imply that if anything, the bill would likely widen deficits over the next few years by an additional 0.8 percentage points of GDP.
Higher import duties under current U.S. tariff policy could reach 1%-1.5% of GDP, which could partly offset near-term deficit expansion, although lower corporate tax collections from reduced earnings will be an offset the other way, regardless of corporate tax changes. The president's unilateral implementation of tariffs indicates that he or a future president can also unilaterally suspend them, raising questions about their longer-term durability as a revenue stream. The constitutionality of the president's tariff policies is also being tested in the courts, potentially reaching the Supreme Court in 2026.
Overall, the 2025 tax and spending bill is projected to add $4-$5 trillion to the U.S. deficit over 10 years (versus the alternative of letting the TCJA provisions expire, with no new legislation), pushing the 2026 deficit to about 6.5%-7% of GDP, even after accounting for tariff revenues.
Gauging future ratings action
All three major credit rating agencies maintain a stable outlook for the U.S., suggesting further downgrades are not imminent. However, in what appeared to be another warning, Moody's underscored its view that the current stable outlook depends on the U.S. Treasury market's special status as the world's liquid, primary unit of account and perceived "safe" store of value. Moody's specifically pointed to the U.S. dollar's status as the world's reserve currency, and the relative strength of U.S. institutions, in its rating outlook.
We viewed these statements as a warning of the potential costs of an erosion of the Federal Reserve's independence from political pressures in its conduct of monetary policy, after the Trump administration publicly commented that it was "studying" whether to replace Powell. The administration later backtracked on these comments, and we don't expect to see Fed independence on monetary policy decisions fundamentally challenged despite the rhetoric or potential court rulings on executive power over independent agencies - but even raising the question is a troublesome sign for investors and for rating agencies. (Read more in our recent article, "Challenges to Fed Independence.")
Investment implications
Although Moody's downgrade generated headlines, we don't think it's likely to drive forced selling: Moody's simply joined the other rating agencies already in the AA camp.
However, amid elevated debt and deficits and ongoing policy uncertainty, it seems reasonable to expect more policy and market volatility ahead.
In this environment, we suggest investors focus on maintaining portfolio resilience by looking to high quality assets, positioning for steeper yield curves - the curve has already steepened since the U.S. election - and diversifying into global fixed income assets.
Indeed, Moody's downgrade along with varying fiscal dynamics across countries helped underscore our conviction in high quality, globally diversified fixed income alongside intermediate-term U.S. exposures.
The topic of debt, deficits, and the interest rate curve was discussed in depth at last week's Secular Forum, when investment professionals gathered to debate the long-term outlook for economies and markets and identify key trends and investment implications. This informed and organized discourse is key to PIMCO's investment process. We'll publish our annual Secular Outlook next month, drawing on insights developed at the forum.
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