Fitch Ratings’ controversial downgrade of the U.S.’ triple-A credit rating, premised on the basis that surging debt levels and higher interest rates would pressure the world’s largest economy, has elicited a host of responses from investors, analysts and politicians from around the world. 

And while many have agreed, at least in principle, with the underlying basis of Fitch’s move to lower its long-term rating on U.S. debt to AA+ amid the fallout from the spring debt ceiling debacle and the Fed’s aggressive inflation fight, most have pushed back against the decision itself.

Former Treasury Secretary Larry Summers, in fact, called it “bizarre and inept” for the most basic of reasons: the economy is simply a lot stronger than anyone, Fitch included, expected it to be heading into the back half of the year.

“There are some things people shouldn’t worry about,” billionaire investor Warren Buffett told CNBC Thursday of the Fitch downgrade. “This is one.”

The Atlanta Fed’s GDPNow tool, a real-time tracker of U.S., has the economy expanding at a torrid 3.9% pace, a significant expansion from the better-than-expected 2.4% second quarter estimate from the Commerce Department and well ahead of headline inflation rate of 3%. 

Unemployment, meanwhile, is holding at the lowest levels in five decades, at 3.6%, even amid one of the most aggressive Fed tightening cycles in a generation, which has included a 500 basis point increase in the Fed Funds rate over a sixteen month period and billions in bond sales from the central bank’s $8 trillion dollar balance sheet.

All these milestones, it must be remembered, have been reached despite the aforementioned debt ceiling squabble in Washington, a banking crisis that saw the collapse of at least three regional lenders in the early spring, the ongoing war in Ukraine that has lifted energy prices in markets around the world and a muted post-Covid recovery in China that’s pressure emerging market growth and elevated the U.S. dollar.

Soft Landing Hopes

“The fact that we’ve been able to achieve disinflation so far without any meaningful negative impact on the labor market, the strength of the economy overall, that’s a good thing,” Fed Chairman Jerome Powell told reports late last month following the central bank’s quarter point rate hike. 

The resilience has led, reluctantly in many respects, to talk of a so-called ‘soft landing’ for the U.S. economy, a condition in which the Fed is able to tame inflation without a corresponding slump in output leading to recession.

“It has been my view consistently, that we do have a shot (at a soft landing), Powell said. [Federal Reserve] staff now has a noticeable slowdown in growth starting later this year in the forecast, but given the resilience of the economy recently, they are no longer forecasting a recession.”

The soft-landing glidepath is certainly looking smooth: as mentioned, unemployment has barely budged despite inflation having fallen from 9.1% in June of last year to just 3% in June of 2023.

More than 4.2 million jobs have been added to the economy since June of last year, and the S&P 500 is just 5% from its all-time peak. Corporate earnings, while contracting, are coming in ahead of Wall Street forecasts for the second quarter, and the dreaded ‘earnings recession’ is likely to be avoided with a third quarter rebound in collective S&P 500 profits of around 1.1%, according to Refinitiv forecasts. 

Bank of America’s Flow Show report, in fact, said this is the fastest nominal GDP recovery since the Second World War.

“The frequency with which economic data beats expectations has surged recently to historically high levels, lowering the probability of a recession this year,” said Jeffery Roach of LPL Financial in Charlotte, North Carolina.  

“The latest data, including GDP and inflation data reported last week, slightly raised the odds of a soft landing for the U.S. economy, though our base case still calls for a mild and short-lived recession to begin by year-end,” he added.

Bond Market Paradox

The crucial condition that could challenge that case — and deliver the ‘soft landing’ desired by politicians and policy makers alike — may paradoxically lie in the very assets Fitch decided weren’t as safe a bet as German bunds or Swiss francs.

“Berkshire bought $10 billion in US Treasuries last Monday. We bought $10 billion in Treasuries this Monday,” Buffett told CNBC. “And the only question for next Monday is whether we will buy $10 billion in 3-month or 6-month” Treasury bills.

In late March of last year, recession concerns and a hawkish Fed tipped the yield curve, a common term for interest rates across a range of Treasury bonds, into its first inversion since 2019.

That meant 2-year notes were pegged higher than 10-year notes, a condition that typically signals recession, as investors worried about higher Fed interest rates (and sold short-term debt) while fretting about longer-term growth prospects (and buying 10-years notes).

According to a study from the San Francisco Federal Reserve, a sustained inverted yield curve has preceded all of the nine recessions the U.S. economy has suffered since 1955, making it an extremely accurate barometer of financial markets sentiment. 

The curve has remained inverted ever since, and while the economy flirted with technical recession in the fall of last year, its subsequent recovery hasn’t been met with a corresponding move in the bond market.

Bull and Bear Steepening

In fact, as recently as last week, 2-year notes were trading a full percentage point higher than 10-year notes, even as the Fed’s preferred inflation gauge slowed to a two-year low and the Commerce Department published its surprisingly solid second quarter GDP estimate.

Fast forward to today, however, and we’re looking at a 2-year/10-year curve that’s pegged at around 0.74% — and falling — in the wake of the Fitch downgrade. 

Further narrowing is likely to lead to what bond investors call a ‘bull steepening’, in which short-term yields fall faster than longer-term rates.

With inflation slowing, and the job market cooling (while still adding new hires with easing wage growth) investors think the Fed has made its final rate hike of this economic cycle, according to data from the CME Group’s FedWatch.

Furthermore, traders are betting the Fed will begin cutting rates in March of next year, a move that would lead to sharply lower 2-year note yields and a further ‘steepening’ of the curve that would erase the market’s last remaining recession signal.

That said, bonds may also experience what is known as a ‘bear steepener’, in which longer terms rates outpace shorter-term rates, a condition that, while not recessionary, bodes poorly for broader financial markets. 

That’s being played out in recent moves on the 10-year note, which traded at a 9-month high of 4.17% in overnight dealing following both firmer jobs data and the Treasury’s projection of $103 billion in new borrowing over the current quarter. 

Ackman Betting Against Bonds

“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,” said billionaire investor Bill Ackman of Pershing Square Capital, who says he has a substantial short position (betting that rates will rise) in 30-year bonds.

Ultimately, it seems, both the changing shape of the yield curve, and the form in which the change takes place, may determine how markets react to the Fed’s ability to engineer that ‘soft landing’.

Friday’s non-farm payroll report, which is expected to show another 200,000 jobs were added to the economy last month following a pullback in job openings data from the Bureau of Labor Statistics earlier this week, is also a key element of the narrative. 

“The Fed continues to try to thread the needle to achieve a soft landing, balancing interest rate hikes and jobs growth,” said Chris Todd, CEO of labor market analysis group UKG. “As we look ahead to the BLS jobs report on Friday, workforce activity in July did dip slightly, which rules out the possibility of any type of upside surprise. This should be welcome news for the Fed and the markets.”

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