US credit rating downgrade: what it means for the US dollar

Understanding the US Credit Downgrade

Just minutes before futures markets closed for the weekend on Friday afternoon, Moody's downgraded the United States' credit rating from Aaa to Aa1, citing growing budget deficits and rising debt costs. This marks the final major rating agency to reduce America's top-tier status, following Standard & Poor's action in 2011 and Fitch's downgrade to AA+ in 2023. The timing is particularly notable, coming shortly after the House Budget Committee rejected President Donald Trump's proposed tax cut package. Meanwhile, demand for US Treasuries continues to lag as federal deficit forecasts worsen. This combination of rating downgrades, political gridlock, and weakening demand for government debt creates significant pressure on the dollar in international markets, setting the stage for complex valuation challenges.

Initial market reaction

The credit downgrade triggered immediate reactions across financial markets on Sunday night and into Monday's open. US equities, bonds and US dollar all opened appreciably lower and declined throughout the European session as market participants quickly repriced risk assets in response to the heightened concerns about US fiscal stability. The forex market showed particular sensitivity, with dollar volatility spiking around London's open against the euro and the pound. The dollar quickly reversed when US markets opened, however, as investors began to shrug off any foundational implications of the downgrade.

Understanding Bonds and Forex Dynamics

Bonds are typically considered safe havens, rising in price and decreasing in yield when equities decline. However, the recent downgrade has disrupted this relationship by emphasizing concerns about the U.S.'s ability to service its debt. Importantly, the dollar's reaction has been somewhat muted because the downgrade primarily impacts long-term bonds, while short-term bonds remained relatively unchanged. This distinction is crucial since dollar strength correlates more closely with short-term interest rates and yields.

The divergence between long and short-term bond markets helps explain the dollar's measured response. While long-term Treasury yields increased due to the perceived additional risk over extended time horizons, the stability in short-term yields provided some support for the currency. The downgrade implies that long-term borrowing costs may rise due to perceived risks, but immediate liquidity and safety concerns still favor the dollar and short-term US debt instruments in many contexts. This environment presents a unique challenge for forex traders, who must navigate these complexities while considering how central banks might respond to the changing risk landscape of US debt across different maturities.

Currency pairs to watch

The forex market's response to the US credit downgrade has been most pronounced in the EUR/USD pair, which emerged as the primary mover on this news. The euro initially surged against the dollar, climbing all the way near 1.1300 before experiencing a significant reversal by Monday afternoon. Interestingly, traditional safe-haven currencies like the Swiss franc (CHF) and Japanese yen (JPY) didn't gain as much ground against the dollar as might have been expected when US debt was deemed riskier. This muted reaction suggests that despite the downgrade, the dollar retains considerable strength relative to these traditional safe havens, possibly due to the still-favorable short-term interest rate differentials or persistent global dollar demand.

Regardless, USD/JPY emerges as the pair to watch going forward, as Japan remains the largest foreign holder of US Treasuries. Any shift in Japan's treasury investment strategy—whether maintaining current levels or reducing exposure—could introduce significant volatility to this currency pair. If Japanese investors begin to demand higher yields or reduce their Treasury holdings in response to the downgrade, this could create additional pressure on both the bond market and the dollar-yen exchange rate. This dynamic underscores how interconnected the global financial system remains and how policy responses from major US debt holders could amplify or mitigate the downgrade's currency impact in the coming months.

How to trade US dollar

1. Open an account to get started, or practice on a demo account
2. Choose your forex trading platform
3. Open, monitor, and close positions on USD pairs

Trading forex requires an account with a forex provider like tastyfx. Many traders also watch major forex pairs like EUR/USD and USD/JPY for potential opportunities based on economic events such as inflation releases or interest rate decisions. Economic events can produce more volatility for forex pairs, which can mean greater potential profits and losses as risks can increase at these times.

You can help develop your forex trading strategies using resources like tastyfx’s YouTube channel. Our curated playlists can help you stay up to date on current markets and understanding key terms. Once your strategy is developed, you can follow the above steps to opening an account and getting started trading forex.

Your profit or loss is calculated according to your full position size. Leverage will magnify both your profits and losses. It’s important to manage your risks carefully as losses can exceed your deposit. Ensure you understand the risks and benefits associated with trading leveraged products before you start trading with them. Trade using money you’re comfortable losing.