The recent downgrade of the United States' debt rating by Fitch Ratings has sent shockwaves through the financial markets, raising significant questions about the sustainability and outlook of U.S. fiscal policyWith the issuance of government bonds exceeding expectations, there's been a swift increase in U.S. bond yields, reflecting investor anxiety surrounding the nation’s creditworthiness and the overall economic environment.

Since March of this year, the U.S. stock market had been on a remarkable upswingBoth the S&P 500 and the NASDAQ experienced continuous monthly gains, boasting year-to-date increases of approximately 16% and 33%, respectivelyThis momentum was initially fueled by robust earnings reports and resilient consumer spending, despite the Federal Reserve's ongoing interest rate hikes and recent banking liquidity concerns.

However, as August arrived, this bullish trend was temporarily disrupted by a convergence of negative factors culminating in a “double whammy” for both the equity and bond marketsThe yield on the 10-year U.STreasury bond surged to around 4.2%, approaching levels not seen since late 2022.

The primary trigger for this market volatility was Fitch's decision to downgrade America’s long-term foreign currency debt rating from AAA to AA+. This marked the first downgrade of U.S. debt by Fitch since the agency began rating U.S. bonds and came as a stark reminder of the fragility in American fiscal managementFitch's report cited expectations of continued fiscal deterioration over the next three years, alongside a significantly higher and growing overall government debt burden.

During the COVID-19 pandemic, the U.S. government undertook large-scale financial relief measures, leading to a dramatic spike in fiscal deficits

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In 2020 and 2021, the deficit reached unprecedented levels at 14.9% and 11.9% of GDP, far exceeding figures recorded during the financial crisis of 2008. Although deficit levels declined in 2022, Fitch's outlook anticipates they will remain above 6% for the foreseeable future, signaling systemic financial challenges ahead.

It’s intriguing to note that in 2011, when Standard & Poor’s downgraded the U.S. credit rating, bond yields fell while the dollar appreciated as global risk appetite diminishedInvestors flocked towards U.STreasuries and the dollar as safe-haven assetsIn stark contrast, today's markets reacted differently; Treasury yields rose sharply even as the dollar lost ground after Fitch's announcement.

This divergent reaction could be attributed to several factors, including the anticipated issuance of over a trillion dollars in new U.STreasury bondsWith many emerging market economies reducing their U.STreasury holdings, liquidity in the Treasury market has tightened considerablyFurthermore, potential shifts in monetary policy by the Bank of Japan may further impact investor appetite for U.S. debt.

Analysts believe that these fluctuations may merely represent short-term market jittersSome, such as those at CICC, argue that supply shocks will primarily create volatility without altering the underlying trendWith the Federal Reserve's interest rate hikes nearing their conclusion, bond yields may gradually trend downward over time.

As of August 1, Fitch's downgrade announced America’s long-term foreign currency debt rating was a reflection not only of fiscal deterioration but also of entrenched issues regarding the debt ceilingEven though the most recent impasse was resolved, recurring political gridlocks continue to foster uncertainty and concern among investors.

Fitch emphasized that over the past two decades, standards of governance in the U.S. have deteriorated, citing repetitive political stalemates surrounding the debt ceiling, which cast doubts on the country's fiscal management competencies

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Many observers are cautiously comparing this recent downgrade to the events of 2011, wherein similar circumstances led to considerable market turbulenceIn that instance, U.S. stocks fell by more than 15% shortly after the downgrade.

The backdrop in 2011 was notably dire, with Europe confronting severe sovereign debt crises that exacerbated fears of a U.S. recessionSubsequently, the Federal Reserve reacted quickly, implementing a program known as "Operation Twist," aimed at reducing long-term bond yields by selling short-term securities to buy longer-term ones.

Today’s economic landscape differs significantly from that of a decade agoCICC suggests that the Fitch downgrade is not as immediate or severe, as it follows a resolution of the debt ceiling crisis several months priorMoreover, the Federal Reserve's rate hike expectations are showing signs of deceleration, while the U.S. economy continues to show signs of growth, suggesting a more stable liquidity environment.

In the short term, the Treasury Department's need to issue bonds to replenish the Treasury General Account (TGA) is evidentFollowing the resolution of the debt ceiling standoff, TGA balances soared from $23 billion in early June to $458 billion by early August, with plans to increase this figure to $650 billion by the end of September.

Recent Treasury refinancing plans indicate expected net issuance in the third quarter alone may rise to $1 trillion, significantly exceeding prior estimatesThe Treasury has scheduled the issuance of $1,030 billion in securities for refinancing, including billions in three-, ten-, and thirty-year bonds.

This spike in bond supply is expected to place downward pressure on bond prices and push yields higher, particularly as the U.S

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Treasury primarily focuses on mid- to long-term securitiesThe question remains, though, about who will purchase this influx of new bondsPrimary holders of U.S. debt include the Federal Reserve, foreign central banks, domestic and international investors, mutual funds, and various deposit institutions.

As it stands, the Federal Reserve is still in a process of balance sheet reduction, meaning it cannot play a significant role as a buyer in the marketInterest in U.STreasuries among foreign investors has also waned over recent years, exacerbated by ongoing global economic realignmentCountries like Russia have almost fully divested from their holdings, Saudi Arabia has noticeably reduced its investments, and Japan has also been scaling back over the past year.

Among foreign investors, Japan remains the largest holder of U.STreasury securitiesHowever, recent adjustments in Japan's monetary policy have raised concerns about further sell-offsAs part of its yield curve control (YCC) strategy, the Bank of Japan decided to maintain its 10-year yield fluctuation range, but any breach of the upper limit could trigger buying operations at a fixed rate of 1%. Such shifts could catalyze further increases in U.S. bond yields.

Despite the uncertain backdrop, analysts from CICC argue that a downgrade does not equate to a higher risk of U.S. debt defaultThey believe that the current mismatch in bond supply and demand is unlikely to persist in the long runAfter surging, U.STreasury yields are exhibiting signs of having overshot their levels, with a relatively stable midpoint near 3.8%. However, without expectations of rate cuts from the Fed, a significant downturn in bond yields is improbable in the immediate future.

Yet, it is crucial to acknowledge that America’s finances, constrained post-pandemic and compounded by the Fed's continued rate hikes, are under intense pressure

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