The US Dollar is weaker, and long-term yields are rising. The S&P futures are down 1.0% after Moody’s downgraded the US sovereign rating from Aaa to Aa1. Moody’s is now the last of the big three ratings agencies to lower the US rating, following S&P’s downgrade in 2011 and Fitch’s in 2023. Moody’s pointed to increased US government debt and higher interest payment ratios compared to other similarly rated countries. There are also doubts about the effectiveness of current fiscal proposals to reduce deficits. This downgrade occurred after the House Budget Committee approved a tax and spending package that includes cuts to Medicaid and clean energy subsidies.

Impact of the Downgrade

The downgrade may lead to more selling of USD assets. Since Moody’s is the last major agency to downgrade, the risks highlighted could intensify USD selling. Recent trends show that selling pressure on the USD might continue. The new bill indicates that US deficits will remain at 5% to 7% of GDP, which could lead to higher yields that offset any potential growth benefits. Before the downgrade, a short USD/JPY trade was suggested, and risk aversion has now increased. The BoJ has mentioned the possibility of raising policy rates if economic conditions support it, putting more pressure on USD/JPY. This downgrade from Moody’s adds more stress to risk assets and fixed income markets. While a downgrade from Aaa to Aa1 wasn’t completely unexpected, the timing and finality were significant since Moody’s was the last major agency to adjust its view of US credit. This shift makes it harder to ignore fiscal strain in the US, and market actions are reflecting this. The S&P futures falling over 1% shows market unease after Moody’s warned about rising debt levels and unsustainable interest payments. These figures affect how investors view risk. The expectation of continuous deficits at 5% to 7% of GDP—even amidst proposed fiscal tightening—suggests little chance for improvement soon, causing yields to rise, which negatively impacts stock valuations, especially in pricey tech and consumer growth sectors.

Market Reaction and Strategy

Looking at the House’s approval of the new tax and spending bill, it offers limited support for debt management. Cuts to Medicaid and green subsidies may relieve some budget pressure, but they won’t change the overall trend. Higher bond issuance will be necessary to cover persistent shortfalls, leading buyers to demand higher yields, thus pushing long-term Treasury yields up. This brings us to the dollar. The recent drop in the dollar’s value aligns with expectations following such a downgrade. The situation isn’t in immediate panic mode, but it reflects a gradual repositioning. Yield differences continue to influence foreign exchange. As US long-term rates increase without support from the currency, pressure on the dollar builds. For instance, USD/JPY is a clear example. The strategy to short the dollar before the downgrade gained importance after a broader decline in risk sentiment. Even though Japanese yields are low, recent comments from the BoJ show they are ready to raise rates if inflation meets expectations. They are preparing for a gradual normalization, which affects funding cost expectations. With rising risk aversion and a comparatively stronger fiscal picture in Japan versus the US, the dollar faces greater vulnerability. During such times, implied volatility tends to increase, reflecting strong demand for protection. We see wider ranges being priced in, especially for FX options linked to USD. For pairs like USD/JPY, this suggests we might enter a phase with clearer directional trends, but the paths could be uneven. In practical terms, we should closely monitor how fixed income markets respond in the coming sessions. A sustained rise in yields, particularly at the long end, could create pressures in sectors sensitive to duration. While USD shorts may not yield quick returns, the current backdrop favors stronger currencies with less fiscal burden. For positioning, it seems wise to keep duration light and maintain high optionality. The current macro environment tends to generate negative surprises, and market reactions can be exaggerated during illiquid trading periods. It’s not about making drastic changes, but rather adjusting our perspective, allowing volatility to work in our favor, and acting when data confirms a direction. Create your live VT Markets account and start trading now.

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