The U.S. sovereign credit rating was lowered one notch by Moody's last Friday. We review how the S&P 500 moved following prior credit downgrades, and highlight potential paths given the current technical picture.
On Friday (5/16), Moody’s lowered the U.S. sovereign credit rating by one notch to Aa1 citing concerns about the growing national debt. Moody’s is the last of the three major rating agencies to lower the US’s rating; S&P was the first to downgrade the US credit rating, dropping it from AAA to AA+ in August 2011, while Fitch Ratings cut their rating from AAA to AA+ in August 2023. With US credit downgrades being such rare events, we through it would be useful to see how the market reacted the two previous times the US rating was lowered.
On August 5, 2011, S&P downgraded the US’s long-term credit rating from AAA to AA+ four days after Congress raised the US debt ceiling following a contentious debate. On the day of the downgrade (8/5), US Treasury yields rose modestly from the previous day’s levels. But, by the next trading day (8/8) yields had fallen back to their pre-downgrade levels. One month later, the curve had shifted downward and had fallen further by the end of the year.
The S&P 500 (SPX) was relatively flat on the day of the S&P downgrade, however, the next trading day (8/8) SPX finished the day down more than 6.5%. While there was a significant sell-off following the downgrade, it is worth noting that the index had already begun to decline. SPX had rallied through most of the first half of 2011 and reached 1370 in May, its highest level since 2008. SPX then reversed down and fell to a sell signal in June. The index consolidated in July before completing a bearish triangle at the end of the month. The decline picked up steam following the credit downgrade in August and the S&P finished the month down more than 5.5%. It wasn’t until October that the S&P reached 1290, where it had broken to the downside in late July. SPX ultimately finished 2011 around 1260, flat on a price return basis, and up just over 2% on a total return basis.
There was a significant shift in the relative strength of the market following the 2011 downgrade, largely favoring value/defensive sectors over growth. Consumer non-cyclicals stood in eighth place in the DALI sector rankings in late July but rocketed to first by mid-August. Healthcare, which had ranked seventh, rose to third by early October. Technology, which ranked fifth at the end of the July, fell to eight by the end of August, and energy, which had ranked third, fell to sixth by the first week of September and finished the year in ninth.
The immediate reaction to the 2023 downgrade was less pronounced. The S&P 500 (SPX) was down 1.4% the following day and was down 1.7% a week later. The S&P saw a peak-to-trough decline of about 5.5% in August, but rallied, finishing the month down 1.6%. The index fell further in September in October before staging a blistering rally that saw it gain almost 14% in the last two months of the year.
Long-term US Treasury yields had begun to move higher before the downgrade – the US Treasury 10-year Yield Index (TNX) returned to a buy signal and positive trend in May 2011 and gave a second consecutive buy signal in July. TNX continued higher in August and reached its highest level of the last decade in October, before dropping precipitously at the end of the year.
We cannot know exactly how the market will react this time around. As we discussed, the reaction was more subdued following the second downgrade in 2023, so it’s possible that the market will be less surprised by a third downgrade and the effect will be muted. The current technical picture for the S&P 500 remained unchanged during Monday’s trading, suggesting investors may be looking past the most recent rating change. On the other hand, there have already been concerns about the sustainability of the national debt and the S&P has gained more than 20% from its April low, so this could be a potential catalyst for profit taking.
The default chart for SPX rose to 5950 during the market action last week, sitting three boxes shy of the all-time highs of 6100 that were last seen in February. The index is sitting around +54% on its trading band, which is not what we would consider overbought, but is the highest weekly OBOS level seen since the first week in December. We are also on a notable stem with initial support not seen until 5150. Overall, the technical picture is decidedly positive, but the extended rally seen over the past two weeks does suggest a heightened potential for consolidation before we test new highs. Remember that trading bands can consolidate in two ways, either through a pullback in price, or a passing of time. The chart would reverse into a column of Os at 5800 from the current level, which would put us around prior support from January. A retraction from the current position would be perfectly normal, perhaps even healthy, allowing the market to establish near-term support before attempting to march higher.
