Dollar Plunges After Moody’s Downgrade

May 19, 2025

Win Thin

Moody’s cut the U.S. rating a notch to Aa1 from Aaa late Friday afternoon; the dollar bear trade remains intact; the House Budget Committee approved an updated tax and spending package; the Q2 growth outlook is solid
The UK-EU summit takes place today; ECB President Lagarde spoke about the exchange rate
China reported soft April real sector data

The dollar remains under pressure after the Moody’s downgrade. DXY is trading at the lowest since May 9 near 100.137 after Moody’s downgraded the U.S. to Aa1 late Friday (see below). UST yields are higher while U.S. equity futures are lower. The synchronized selling of USD, Treasuries and US stocks highlight the growing loss of confidence in the US economy. Bottom line: USD is vulnerable to more downside this week. USD/JPY is trading at the lowest since May 8 near 144.75. Elsewhere, the euro is trading higher near $1.1275 as Lagarde shows no concern about currency strength (see below) and sterling is trading higher near $1.3395 as the EU-UK summit gets under way (see below). We continue to view any dollar relief rallies with skepticism. Easing trade tensions have removed a significant headwind on the dollar over the short-term, but those tensions are likely to pick up over the next few weeks as the new (and higher) tariffs kick in. Ultimately, though, the Moody’s downgrade has reminded markets of the growing U.S. risks and so dollar weakness is set to continue.

AMERICAS

Moody’s cut the U.S. rating a notch to Aa1 from Aaa late Friday afternoon. The agency cited the increase in government debt as well as a higher interest burden and noted “While we recognize the US’ significant economic and financial strengths, we believe these no longer fully counterbalance the decline in fiscal metrics.” The move should not be too surprising after Moody’s cut the outlook on its Aaa rating to negative back in November 2023. S&P was the first to move the U.S. below AAA back in August 2011, while Fitch followed suit back in August 2023.

The market reaction to the S&P downgrade on August 5, 2011 was significant. On August 8, 2011, the first trading day after the downgrade, the S&P 500 plunged nearly 7% while Treasury yields paradoxically fell on safe haven demand and USD ticked up. In contrast, the market reaction to Fitch Ratings’ downgrade on August 1, 2023 was muted. One reason is that post-2011, most institutional investors had shifted away from requiring only AAA-rated debt in their investment mandate.

Following Moody’s downgrade, 10-year Treasury yields have risen nearly 10 bp to 4.54%. Further yield upside seems limited, however, as investors remain largely unfazed by the chronic US fiscal imbalance. Indeed, the Congressional Budget Office (CBO) projects the federal debt to balloon from currently 98% of GDP to a record high of 155% of GDP in 2055. However, foreign holdings of US Treasuries surged to an all-time high of $7.63 trln in March even as the compensation investors require for holding long-dated Treasuries (the term premium) remains historically low.

That said, the dollar bear trade remains intact. Trade policy uncertainty, doubts about the rule of law, an escalating fiscal burden, and perceived interference with the Fed’s independence all threaten to make the U.S. a less attractive place to invest. The synchronized selling of USD, Treasuries and US stocks highlight the growing loss of confidence in the US economy. Bottom line: USD is vulnerable to more downside this week.

The House Budget Committee approved an updated tax and spending package. A vote by the entire House of Representatives is anticipated before Memorial Day (May 26). If passed by the House, the bill moves to the Senate, where it is expected to undergo significant changes. As things stand, the nonpartisan Tax Foundation estimates the House bill would add $3-4 trln to the nation's debt over the next decade while the Committee for a Responsible Federal Budget says the cost could be as high as $5.3 trln.

The Atlanta Fed’s financial markets conference will be held this week and features numerous Fed speakers. Bostic (twice), Jefferson, Williams, Logan, and Kashkari all speak today. All are expected to maintain the cautious stance set forth by Powell. The odds of a June cut have fallen below 10%, are around 40% in July, and are around 90% in September. Looking ahead, the swaps market is pricing in around 75 bp of total easing over the next 12 month, down from 125 priced in earlier this month.

The Q2 growth outlook is solid. The Atlanta Fed GDPNow model now has Q2 growth at 2.4% SAAR and is right back at its initial estimate. It will be updated next Tuesday May 27 after the data. Elsewhere, the New York Fed Nowcast model now has Q2 at 2.3% SAAR and will be updated Friday, while its initial Q3 estimate will come at the end of May.

EUROPE/MIDDLE EAST/AFRICA

The UK-EU summit takes place today. This is the first leader level post-Brexit summit and is expected to focus on defense and resetting post-Brexit relations. Closer UK-EU trade relations can lead to a more favorable UK business investment outlook, which bodes well for GBP.

European Central Bank President Lagarde spoke about the exchange rate. She pointed out over the weekend that the recent strength in the euro against the dollar “is counter-intuitive but can be explained by the level of uncertainty and the fact that some parts of the financial markets are losing confidence in US policies.” We concur. Indeed, the move towards deeper European Union integration is another factor underpinning EUR strength. Lagarde’s comments suggest the ECB is not concerned about currency strength. A cut at the next meeting June 5 is nearly priced in, while the swaps market is pricing in about 50 bp of total easing over the next 12 months that would see the policy rate bottom near 1.75%.

ASIA

China reported soft April real sector data. Retail sales came in at 5.1% y/y vs. 5.8% expected and 5.9% in April, IP came in at 6.1% y/y vs. 5.7% expected and 7.7% in March, and fixed asset investment came in at 4.0% YTD vs. 4.2% expected and actual in April. Commercial banks set their Loan Prime Rates Tuesday and expected to cut the 1- and 5-year rates 10 bp to 3.0% and 3.5%, respectively. These cuts would simply reflect the recent 10 bp cut in the 7-day reverse repo rate. With deflation risks persisting, we expect further stimulus measures in the coming weeks.

Brown Brothers Harriman & Co. (“BBH”) may be used as a generic term to reference the company as a whole and/or its various subsidiaries generally. This material and any products or services may be issued or provided in multiple jurisdictions by duly authorized and regulated subsidiaries.This material is for general information and reference purposes only and does not constitute legal, tax or investment advice and is not intended as an offer to sell, or a solicitation to buy securities, services or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code, or other applicable tax regimes, or for promotion, marketing or recommendation to third parties. All information has been obtained from sources believed to be reliable, but accuracy is not guaranteed, and reliance should not be placed on the information presented. This material may not be reproduced, copied or transmitted, or any of the content disclosed to third parties, without the permission of BBH. All trademarks and service marks included are the property of BBH or their respective owners.© Brown Brothers Harriman & Co. 2024. All rights reserved.