Post from First Trust Economics Blog

Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Deputy Chief Economist 

May 27th, 2025

Moody’s finally downgraded US government debt on May

16th to Aa1, its second highest rating. With the US $36 trillion

(and rising) in debt, it’s not hard to see why. But Moody’s was

late to the party with S&P and Fitch (the other two major ratings

agencies) having done so long ago.

The financial media went berserk, but long-term bond

yields have not exactly soared. The 10-year Treasury yield

closed at 4.43% the night before the downgrade and 4.51% this

past Friday, eight days later. The 30-year Treasury yield moved

up more but, again, didn’t skyrocket, closing at 4.89% on the eve

before the downgrade and 5.04% as of last Friday.

What has received more attention is the gap between the

yield on the 30-year and the 10-year, which has grown to 50+

basis points, noticeably higher than the 20 basis points it

averaged in 2024. However, the yield gap averaged 44 bps in the

year prior to COVID, so not much change.

It’s hard to separate the impact of all the moving parts

affecting the bond market. For example, Federal Reserve

officials have made it clear that near-term rate cuts are, from their

perspective, not warranted. So, was it the downgrade or the Fed

that put pressure on the market?

S&P downgraded US debt back in 2011 and Fitch in 2023,

with no calamity as a result. S&P’s downgrade came in the

Obama Administration, Fitch’s during Biden/Harris.

Like then, the downgrade is being used to bash politicians,

this time the Trump Administration and Republicans in Congress

for moving ahead with efforts to extend the tax cuts originally

enacted back in 2017. Moody’s criticizes the extension as being

fiscally irresponsible. Wider deficits, according to the analysts,

lead to higher interest rates on higher debt and a greater interest

burden for the government to finance, leading to even bigger

deficits, and so on and so forth.

The problem with this theory, though, is that the policies

being pursued are not going to lift budget deficits beyond the

policies that are already in place. In other words, why wait until

now to downgrade debt based on current policies?

Spending soared after COVID, even with the economy

opening up and unemployment at 4% or less. It was the spending

that created $2 trillion deficits and the Biden Administration

never talked about tax hikes.

The Big Beautiful Bill includes some spending cuts.

According to the Tax Foundation, a non-partisan think tank, the

bill recently passed by the House will reduce the deficit by

roughly $1.9 trillion in the next ten years compared to a simple

alternative of passing a bill that merely extended the 2017 tax

cuts for the next ten years. That’s because the latest bill includes

both higher expected revenues as well as some reforms to

entitlements, like Medicaid.

In addition, tariffs should generate some extra receipts and

the Trump Administration has proposed steep cuts to nondefense

discretionary spending for Fiscal Year 2026 (starting

October 1), calling for 32% less spending on these programs

versus what the Congressional Budget Office assumed back in

January. If those cuts happen, the “baseline” for future spending

could be a few trillion lower in the next decade.

None of this is to suggest that the US fiscal position is good;

it’s certainly not. In spite of record tax revenue, spending is so

high that budget surpluses are nowhere in sight. Back in 2007,

the budget deficit was only about 6% of federal spending. In

other words, it wouldn’t have taken many spending cuts to get to

a balanced budget.

But by 2019 (the year before COVID), the budget deficit

was 22% of federal spending. Now it’s 27% of federal spending.

Imagine cutting your household budget by 27%!

The good news is we don’t have to run surpluses to make

our debt position manageable. At a minimum we want overall

debt to grow no faster than nominal GDP.

The more we reduce the deficit by cutting spending, the

more resources stay in the private sector, setting off a virtuous

cycle of more growth, more revenue, and smaller deficits. It

happened under President Clinton. Now that the Senate has the

bill, can we do it again?