Debt ceiling crisis lurks around the corner
In this post, let’s talk about how the recent rise in stock markets, cryptos and gold may be partly explained by the improvement in liquidity, which I highlighted as a driver in this post a month ago. The US debt ceiling is approaching and populist speculation about market chaos and the country's insolvency is hitting the headlines. As per usual, let's take a coolly analytical approach. Before that, let's briefly review the news of the last few days.
Comments on the news of the last few days
Let's start with a brief word on the earnings season and a few macro remarks, if I may. In Finland, the epitome of motorsport, the coughing of the Duell engine continues. The company published its exceptional Q1 results yesterday. Retailers are still depleting their own inventories due to weak consumer demand, and so Duell's own money is literally stuck in the products in their own hands. The company's financial situation is tight, to put it mildly, unless the goods start moving later this year. The company is negotiating a new financing agreement for the spring.
In the US, the big banks Goldman Sachs and Morgan Stanley report their results. Both banks are more Wall Street-driven, so results were lackluster in the absence of big deals. Investment banking fees were halved. Like other banks, both would sweep more money aside for future credit losses.
Although lending plays a smaller role than to the other major banks, this is a good opportunity to highlight this graph from the Fed's survey of loan officers. It shows what percentage of US banks are tightening lending criteria for medium and large firms. As you may notice, such a number of banks tightening the criteria has often preceded economic downturns. The economy runs on credit, and if you don't get it, the wheels slow down.
The latest weak retail sales data and quickly receding PPI also indicates cooling economy. Yield curve inverted further after the lackluster data releases, indicating recession sometime in the future.
Liquidity has continued to improve
One reason for the recent greening of equities may be the improvement in liquidity conditions. A month ago, I showed this curve of the Fed's net liquidity in the post titled 'The Fed has already pivoted'. The blue line represents the Fed's net liquidity, i.e. the balance minus the Federal current account at Fed and reverse repurchase agreements. It's a bit technical, but the main point is that the money just sits in those accounts and doesn't circulate. The red line is the S&P 500. Visually, the two bounce side by side. Liquidity feeds equities, and if it dries up, the market sentiment sinks.
Liquidity also fuels more speculative asset classes sensitive to asset class inflation, such as gold and cryptos. Both have risen nicely as of late. This CrossBorder graph shows the six-month annualized change in these asset classes and global liquidity.
Officially, the Fed is tightening monetary policy and shrinking its balance sheet at a rate of 95 billion per month, so it is surprising that liquidity hasn’t actually decreased since the summer. The main reason for this has been the high spending on the federal current account at the Fed. This is the account from which the federal government pays almost all its contributions. The account stood at almost $2,000 billion at the height of the interest rate crisis but has now fallen below $400 billion.
Some liquidity experts such as Michael Howell of CrossBorder Capital argue that the Fed and the federal government are operating in lockstep on monetary matters, and this is a deliberate way to ease the drying up of market liquidity. As I explained in the above-mentioned post, the Bank of England had to bail out the market last fall. All central banks fear a similar disruption in the bond market. As the federal current account burns towards zero, we will find out whether the Fed has really turned its coat. At that point, balance sheet erosion should stop altogether. We will find out soon enough.
The debt ceiling circus waits ahead
Hold onto your hats, for the biennial political circus around US debt is about to start up again. The US public sector spends more than it earns in taxes, so it runs a fiscal deficit. Thus, part of public expenditure has to be financed by debt.
However, in the US, there is a strange political pattern of setting a debt ceiling, i.e., how much the federal government can hold in absolute maximum public debt. Now the limit is $31.4 trillion, and that figure is already approaching very quickly. The default, or at worst chaos, of the world's largest economy and most important bond market isn’t the first thing on an investor's wish list. Republicans and Democrats in Congress should unanimously raise the debt ceiling, but the opportunity to make demands on the other party by threatening an economic nuclear winter is far too delicious for politicians to pass up. So, this time, too, there is an unfortunate stalemate, and the Democrats so far seem in no mood to bend to the Republicans' demands for cuts. Ironically, some people think the whole debt ceiling will limit public debt, but both parties have been running large public deficits for decades.
Treasury Secretary Yellen warned that today, Thursday, the federal government will have to launch "extraordinary measures" to postpone the default. I don't know exactly what that means, but I guess public agencies are funded for the time being by donations and other forms of charity. Bloomberg estimates that with these emergency measures, the federal government could manage until October without raising the debt ceiling.
If no agreement is reached, some public services will simply cease to function when they can no longer be financed without additional debt. This is what happened in the debt ceiling crisis of 2011.
The impact on the market can be significant. At the time, the S&P500 plummeted by 20% in a short space of time and one credit rating agency even dared to downgrade the US credit rating by one notch. However, in fall 2011, the euro crisis hit at the same time and investor sentiment was still fragile because financial crisis was fresh in our minds.
The risk is worse if the dispute continues for a long time and the federal government is unable to pay its maturing bonds. This would push the US into technical insolvency, which would erode confidence in the center of the global financial system.
Although the debt ceiling crisis sounds dramatic, I have a few comforting points to make. First, this circus is repeated every couple of years and finally the politicians have come always to an agreement. As politics has polarized over the years, the disputes have become intense, with one Republican senator comparing the debt-ceiling debate to a knife fight. However, I would think that the threshold to really drive your country into insolvency is quite high.
Second, insolvency would be entirely technical in nature and political in decision. The United States is indebted in its own currency, the dollar. In theory, the federal government can run up an infinite amount of debt, because the Fed can help with the loans. This circus has nothing to do with the country actually being insolvent. The debt-to-GDP ratio is now around 120% which is historically high as you can see from this graph, but it's under control for now.
Third, the US, with its deep capital market, is the world's largest savings park-a-lot. The dollar is the main trading currency. China, Germany, Japan, the oil countries and other current account surplus exporters are forced to park the money they earn somewhere. For example, this great Excel graph by Brad Setser shows how nicely the surpluses of exporting countries and the deficits of the US mirror each other. It's a more philosophical question whether the US debt is due to over-saving in these countries or vice versa, but the essential point to understand here is that there is no rival in the world for a savings park-a-lot the size of the US. Everything is big in America, and so is the country's ability to absorb other savings from elsewhere. This is why the dollar reserve currency position is also secure at the moment, because no one else seems to want a similar dumping ground for savings. Therefore, the impact of the debt ceiling circus on the country's credibility should not be overestimated, because there are no realistic alternatives.
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