Week ahead: A US debt downgrade and UK CPI

This week we should be talking about how in May, US equities have  outperformed their European counterparts. However, instead the focus will be on the US credit rating downgrade from Moody’s that was announced late on Friday night. The US credit rating agency is the last of the major agencies to downgrade the US from Aaa to Aa1. The US no longer has the coveted triple A credit rating, leaving Australia, Canada, Germany and others to have higher rated credit than the US.

Swift reaction to downgrade news

The reaction to this news has weighed on US equity futures, which are sharply lower on Monday, and it has also knocked the US dollar. Treasury yields are higher across the board, and the 30-year yield breached the key 5% level on Monday morning. While we do not think that there will be a mass exodus from US assets this week, it could lead to more mutterings about diversification away from US assets.

The impact on risk sentiment has been broad-based, and there were also declines for stocks in Asia and European futures are also lower. If we see a move out of Treasuries, and gains for bonds elsewhere, then we could see global stocks ex the US make a recovery.  

US’s credit risks have grown over the last 14 years

The downgrade is to be expected. S&P 500 ditched the US triple A grade back in 2011. Back then, S&P said that the rating downgrade was due to risks around governance and policy making stability, and downwardly revised its revenue forecasts for the US government. Exactly the same problems exist 14 years later. The House Republicans are currently debating President Trump’s fiscal bill that is designed to reduce taxes and cut government spending but would still increase the deficit. The difference between today and 2011 is the sheer scale of the US’s debt problem. Moody’s expects the current fiscal bill to cost $3.8 trillion over the next decade, and federal deficits to widen. They predict the deficit could balloon to 9% of GDP by 2035, up from 6.4% in 2024, driven mainly by high interest payments.

Public voted for Trump and his impact on the Federal deficit

This is not unexpected. Ahead of the November 2024 Presidential election, the Committee for a Responsible Federal Budget reported that the fiscal impact of Kamala Harris’s campaign pledges would be $3.95 trillion, they reported that President Trump’s policies would cost $7.75 trillion. Thus, the American public voted for a President that they knew would increase the size of the deficit.

Will China continue to buy Treasuries?

The downgrade comes at a sensitive time for the US Treasury market. The Treasury announced last week that China’s holdings of US Treasuries had fallen to third place, behind the UK in March.  While the absolute value of China’s Treasury holdings has not changed by much, the backdrop of trade tensions between the two nations makes the stakes higher for the US. We do not expect any large decline in China’s holdings of US debt in the coming months, however, it could be the start of a trend whereby China is less willing to finance an ever-growing US fiscal deficit. We shall have to see if President Trump’s charm offensive will see resource rich Middle Eastern nations pick up the slack from China. For now, this could add to selling pressure on US Treasuries this week.

While 2-year yields are stable, the focus will be on the long end of the US Treasury curve at the start of this week. The 10-year yield has surged past the highs reached at the peak of the reciprocal tariff panic in April, while the 30-year yield has breached the 5% level, which is the highest rate since 2023. The jump in yields on Monday morning is not supportive of the dollar, as fiscal concerns are rarely FX positive. The dollar was the weakest performer in the G10 FX space last week. In early trading this week, the dollar is weaker. USD/JPY is extending losses after falling though its 50-day sma at the end of last week at 146.10. Fiscal concerns, and Moody’s credit rating downgrade could trigger further downside for the greenback, with 142.50, a key short term support level.

Keep an eye on Washington, delays to Budget bill could sooth market deficit fears

House Republicans have a new deadline of 26^th May to pass the US Budget bill, before it goes to the Senate, where it also needs to be passed before it can be signed into law by the President. At this stage, we think any delay or resistance to the Budget bill could be welcomed by the markets, especially if it causes positive fiscal effects. The risk for traders in the coming days, is that tax cuts are agreed, without enough cuts to government spending, which could blow up the US fiscal deficit, and trigger a sell off in Treasuries, the US dollar and eventually in US stocks. We will be watching developments in Washington closely this week.

Global equities will also be in focus this week. US equities outperformed their European counterparts last week, and there were big gains for US tech stocks, after President Trump brokered deals with Middle Eastern countries for US AI chips and infrastructure. The S&P 500 ended last week less than 50 points away from the key 6,000 level, and it was closing in on the record high from 19^th February at 6,147. On Monday, the market has retreated further from this level, which suggests that the size of the US budget deficit is one of the challenges facing the main US blue chip stock index as it tries to make fresh record highs. The Nasdaq has risen by more than 10% so far in May, and Nvidia’s share price is higher by more than 30% in the past month and has nearly eroded all of its losses so far in 2025. However, tech could be in the firing line at the start of this week, and it may come under pressure as US yields rise.

Growth stocks like tech have led the S&P 500 higher in the past week, momentum and liquidity have also been big drivers of the stock market recovery in recent weeks. Anything that threatens market liquidity, like a spike in long end US bond yields, could be a threat to the market rally.

While there are key questions facing financial markets this week, such as the impact of the US debt downgrade, and the progress on the US budget, there are also key economic releases that are worth looking out for. We pick the top three releases below.

1. UK CPI

This will be a keenly watched economic indicator for the UK this week. The market is expecting UK inflation to jump to 3.3% in April, from 2.6% in March. The driver of the increase in headline prices is expected to be energy costs. Although the energy price cap fell last month, it is still 6% higher YoY. This increase in prices is expected by the BOE, who expect inflation to remain above target for the rest of this year. Service price inflation is also expected to rise to 4.9% from 4.7%. The Bank of England expects inflation to rise to 3.7% by September, before falling back to the target rate after that. The BOE sees upside risks to inflation coming from service prices, which have continued to rise at a decent clip.

Overall, higher inflation supports the BOE’s ‘careful and gradual’ approach to rate cuts, and it may spur the two MPC members to continue to vote against rate cuts in the coming months. The market is now expecting less than 2 rate cuts for the rest of this year, with the next cut expected in August. The pound has been one of the stronger performers in the G10 FX space this month, after a higher-than-expected growth rate for Q1. GBP/USD is back above $1.33 on Monday morning, but it remains in a consolidation pattern after the UK/US trade deal. This pair will need a new driver to spur further sterling gains. A successful EU/ UK re-set summit, that lays a path to boost trade between the UK and the EU, as well as some freedom of movement, might be the tonic that is needed to get the pound moving again.

2. Global PMI reports for May

The preliminary data set for May could be the biggest economic surprise of the week, since PMI data is expected to show resilience in the world’s largest economies against the backdrop of US trade tariffs. Composite PMI readings in the UK, France, Germany and the Eurozone as a whole, are all expected to register increases in sentiment for this month, while the US is expected to register a small decrease.

All eyes will be focused on the export components. Will the 90-day reciprocal tariff reprieve be enough to boost the Eurozone’s export component above 50, for the first time in 3 years? Will the UK/ US trade deal that was announced recently, provide upside momentum for UK growth in Q2, after stronger than expected GDP for Q1?

Stronger than expected PMI readings could boost risk sentiment, in the short term. However, in the longer term, we continue to think that the pain from tariffs will not show up in the economic data until late in 2025/ 2026. Risky assets like stocks are forward looking, so better-than-expected PMI readings, may not be a long-term driver of higher global stock prices.

3. IFO data to show Germany’s economic rehab continues

Germany’s IFO report for May has a close relationship with German GDP. The IFO is expected to register gains for all three categories, including the expectations sub index. If expectations are correct, then this could be the highest reading for more than 6 months. It would suggest that the German economy is in better shape to withstand the US trade tariffs. Tariff negotiations combined with lower energy prices could trigger another leg higher for the Dax, after it reached a record high last Monday.

Could a resurgent Germany also boost the euro? EUR/USD is hovering around $1.1180. A boost for the German economic outlook, could help the single currency to jump back above $1.12, after a weak performance in the past month. The technical signals are also good, with several higher closes for EUR/USD last week. Eventually, higher levels of German government spending and lower deficit levels than the UK and the US, could boost the euro later this year.