Constitutional Crises or Fiscal Reforms, US Sovereign Credit Rating, A Looming Risk?

Constitutional crises are critical events that can significantly impact sovereign credit ratings. They directly undermine political stability, weaken institutional strength, and create uncertainty around economic policy. These factors are essential for maintaining investor confidence, and any disruption can lead to a reassessment of a country’s creditworthiness.

Recent developments in the United States are concerning and warrant closer attention than many investors are currently giving them. While I am not a constitutional law expert, the ongoing stress on the U.S. constitutional system since President Trump took office—particularly through the use of executive orders and the resulting legal and political clashes—has raised alarms. For example, executive orders on immigration (e.g., the "travel ban") and environmental regulations have faced significant legal challenges, highlighting tensions between the executive branch, the judiciary, and Congress. While there is much talk of "constitutional stress," it is important to distinguish this from a full-blown "constitutional crisis." At this stage, we agree there is stress, but not yet a crisis. However, if this stress escalates into a crisis, the U.S. sovereign credit rating could be at risk.

A downgrade of the U.S. sovereign rating would have far-reaching consequences. As the world’s largest economy and the issuer of the global reserve currency, the U.S. plays a central role in global financial markets. A downgrade could trigger a global crisis, forcing
investors worldwide to reconsider their allocations to U.S. government bonds. In such a scenario, institutional resilience may become secondary to market dynamics, as large-scale sell-offs or shifts in investor behavior could further destabilize financial systems.

This underscores the complex interplay between a country’s systemic importance, market perceptions, and institutional frameworks in determining the ultimate impact of a constitutional crisis on sovereign ratings. For instance, during the 2011 debt ceiling crisis, the U.S. faced a downgrade by Standard & Poor’s, which cited political brinkmanship and eroding governance as key factors. While the immediate market impact was limited due to the dollar’s reserve currency status, the episode highlighted the risks of political dysfunction.

That said, we are not yet in a constitutional crisis. Current U.S. political issues, while chaotic, do not meet the threshold of a crisis. A constitutional crisis typically involves a fundamental breakdown in the functioning of government, such as the inability to enforce laws or resolve conflicts between branches of government. While some may frame the current environment as a crisis, it is more accurately described as a period of heightened constitutional stress. We are closely monitoring the situation and will provide updates if expert opinions indicate that a crisis has emerged.

Key Considerations for Investors:

1. Monitor Institutional Resilience: Pay attention to how U.S. institutions respond to political challenges. The ability of Congress, the judiciary, and the executive branch to resolve conflicts will be critical.
2. Assess Market Sentiment: Even in the absence of a full-blown crisis, market perceptions of political instability can influence investor behavior and asset prices.
3. Prepare for Contingencies: Investors should consider scenarios in which a constitutional crisis leads to a sovereign rating downgrade and plan accordingly.

While the current environment of constitutional stress in the United States poses significant risks to sovereign credit ratings, there is also potential for improvement if the Trump administration’s DOGE team can implement substantial fiscal reforms without escalating tensions into a full-blown constitutional crisis. The interplay between these risks and opportunities will be critical in determining the future trajectory of the U.S. sovereign credit outlook.

Constitutional Crisis Risks

1. Political Polarization: The deepening divide between political parties has led to frequent gridlock, government shutdowns, and brinkmanship over critical issues
   like the debt ceiling. This polarization increases the risk of a constitutional crisis, particularly if branches of government clash over fundamental issues like executive authority or election legitimacy.
2. Debt Ceiling Standoffs: The recurring debt ceiling debates have become a flashpoint for constitutional stress. If Congress and the administration fail to reach timely agreements, it could lead to a technical default, undermining confidence in U.S. governance and triggering a downgrade in sovereign ratings.
3. Election-Related Tensions: The 2024 elections could further strain the constitutional framework, especially if disputes over election results or candidate eligibility lead to prolonged legal battles or political instability.
4. Institutional Erosion: A constitutional crisis could weaken key institutions, such as the judiciary or Congress, reducing their ability to act as checks and balances. This erosion of institutional strength is a key factor in sovereign credit assessments.

Fiscal Reform Opportunities

On the other hand, if the Trump administration’s DOGE team can successfully implement substantial spending cuts and fiscal reforms without provoking a constitutional crisis, it could improve the U.S. sovereign credit outlook. Key factors that could drive this positive shift include:

1. Debt Reduction: Meaningful spending cuts and fiscal discipline could stabilize or
   reduce the U.S. debt-to-GDP ratio, addressing one of the primary concerns of rating agencies.
2. Improved Governance: Effective collaboration between the executive and legislative branches to pass fiscally responsible policies could enhance perceptions of governance and institutional strength.
3. Market Confidence: Successful fiscal consolidation could boost investor confidence,
   leading to lower borrowing costs for the U.S. government and reinforcing the dollar’s role as the global reserve currency.
4. Debt Ceiling Reform: If the administration and Congress work together to reform or eliminate the debt ceiling, it would remove a recurring source of uncertainty and
   improve the U.S.’s fiscal credibility.

Balancing Risks and Opportunities

The key challenge lies in navigating the fine line between fiscal reform and constitutional stability. While spending cuts and fiscal discipline are essential for long-term creditworthiness, they must be achieved without exacerbating political tensions or undermining the constitutional framework. For example:

• Successful Scenario: If the DOGE team can work collaboratively with Congress to pass fiscally responsible policies, it could improve the U.S. credit outlook without triggering a crisis.
• Risky Scenario: If spending cuts are pursued through unilateral executive actions or
  contentious legislative battles, it could escalate constitutional stress and increase the risk of a crisis.

Conclusion

The U.S. sovereign credit outlook is at a crossroads, with constitutional crisis risks on one side and fiscal reform opportunities on the other. While the current environment of political polarization and governance challenges poses significant risks, the potential for improvement exists if the Trump administration can deliver on fiscal discipline without triggering a constitutional crisis. Investors and policymakers should closely monitor these developments, as they will have far-reaching implications for the U.S. economy and global financial markets.

Reach out to discuss the implications of each scenario on global markets, how to prepare, and how to position portfolios effectively, from a duration, sector and style and alternatives perspective.

As Benjamin Franklin wisely said, "By failing to prepare, you are preparing to fail." In today’s uncertain political climate, preparedness is more important than ever.

References:

1. NPR - Are we in a constitutionalcrisis? February 11, 20255:45 PM ET
https://www.npr.org/2025/02/11/1230674436/are-we-in-a-constitutional-crisis
2. Brookings Institute - How is civilsociety responding to the US constitutional crisis?
https://www.brookings.edu/articles/how-is-civil-society-responding-to-the-u-s-constitutional-crisis/

3. US Library of Congress - https://www.loc.gov/item/2021667573/