The US Dollar is weaker, and long-term yields are rising, with the S&P future down 1.0% due to Moody’s decision to downgrade the US sovereign rating from Aaa to Aa1. This marks Moody’s as the last of the big three agencies to lower the US rating, following S&P in 2011 and Fitch in 2023.

Moody’s cited increased US government debt and interest payment ratios, higher than similarly rated countries, and doubts about reducing deficits with current fiscal proposals. The downgrade came as the House Budget Committee approved a tax and spending package involving cuts to Medicaid and clean energy subsidies.

Impact of the Downgrade

The downgrade could lead to further USD asset selling, with risks highlighted by Moody’s judgment being the final one from the big three agencies. Recent trends indicate potential continued USD selling. The agreed bill suggests ongoing US deficits of 5%-7% of GDP, risking higher yields that might offset growth benefits.

A short USD/JPY trade idea was suggested before Moody’s downgrade, with risk aversion now increased. The BoJ indicated the possibility of a policy rate hike if economic projections are realised, putting more pressure on USD/JPY.

From what we’ve seen, the downgrade by Moody’s has introduced a fresh layer of pressure across risk assets and fixed income markets. The move from Aaa to Aa1 itself isn’t unexpected—it’s more the timing and finality of it, considering this was the only major agency yet to lower their assessment of US credit. With this step, the theme of fiscal strain in the US becomes much harder to ignore, and price action appears to be responding accordingly.

The S&P futures falling over 1% is a fair reflection of market unease after Moody’s flagged rising debt levels and unsustainable interest payment obligations as clear concerns. These aren’t abstract metrics; they directly feed into how investors think about risk. Expectation of persistent deficits at 5% to 7% of GDP—even with fiscal tightening on the table—suggests little hope for deficit improvement anytime soon. That causes yields to climb, which then hits equity valuations hard, especially in highly priced tech and consumer growth segments.

Market Reaction and Strategy

Taking a step back, the House’s approval of the new tax-and-spending bill offers limited support from a debt management perspective. Reductions in Medicaid and green subsidies may ease some budget pressure, but they’re not enough to change the overall trajectory. With higher bond issuance needed to cover those persistent shortfalls, buyers will demand greater compensation—hence, the upward pressure on long-term Treasury yields.

That brings us to the dollar. The softer tone in the greenback this week aligns with what we’d expect after such a downgrade. The risk is no longer theoretical. This isn’t about sudden panic, but about steady repositioning. Yield differentials remain a major driver in FX, so as long-term US rates rise without offsetting currency support, pressure builds. We’ve started seeing that now.

USD/JPY is a good example. The idea to short into strength ahead of the downgrade picked up extra weight given the collapse in broader risk sentiment. Japanese yields may still be near historic lows, but recent BoJ commentary from Ueda confirms their growing readiness to hike if inflation stays on track. They’re preparing for normalisation—even if slowly—and that’s enough to cause modest shifts in funding cost expectations. Combine that with rising risk aversion and a relatively better fiscal picture in Japan versus the US, and the dollar’s vulnerability becomes more evident.

In periods like this, implied volatility tends to rise and skew changes reflect more demand for protection. We are already seeing wider ranges being priced in, particularly in FX options tied to USD crosses. For pairs like USD/JPY, this suggests we’re entering a phase where directional clarity may look clearer, but paths remain jagged.

In practical terms, we should be mindful of how fixed income reacts in the coming sessions. A sustained rise in yields—particularly in the long-end—will likely ramp up pressures in duration-sensitive sectors. Meanwhile, USD shorts may not pay off immediately in all cases, but the structural backdrop now favours strength in peers that carry less fiscal baggage.

For positioning, keeping duration light and optionality elevated seems prudent. The macro tone right now is one where surprises tend to skew negative, and price responses are more exaggerated during illiquid trading windows. It’s not about wholesale shifts, but adjusting the bias, letting volatility work in our favour, and pressing when the data confirms the direction.

Create your live VT Markets account and start trading now.