Aftershocks from the debt ceiling standoff
This week's financial events highlight the interconnectedness of global finance
Key Takeaways:
This week's financial events underscore the interconnectedness of global finance
The resolution of the U.S. debt ceiling standoff has implications for the Treasury, money market funds, and banks.
Central banks worldwide continue to struggle with the challenge of inflation and the impact of their monetary policies.
Despite some optimistic economic indicators, bond managers warn of a potential recession due to the after-effects of monetary tightening and bank failures.
Implications for Markets / Consumers
Elevated T-Bill yields (from record-breaking Treasury issuance over the next few months) could place additional strain on already vulnerable bank balance sheets and cause further capital flight from stocks and bonds. This may adversely affect consumers who are already facing financial challenges and could contribute to a recession later this year.
The outlook could change if banks respond to higher T-Bill yields by offering competitive deposit rates, benefiting savers and boosting consumer spending. Improved employment rates and GDP growth in the back half of the year could signal a healthier economic outlook. However, I see all of these as low-probability events
Main Stories This Week:
This week, we examine the resolution of the U.S. debt ceiling standoff, the ongoing battle against inflation by global central banks, and the looming threat of a recession despite some positive economic indicators. These events are interconnected, influencing one another and carrying far-reaching implications for investors, businesses, and everyday consumers.
The U.S. Debt Ceiling Standoff Resolution:
The U.S. debt ceiling standoff has finally been resolved, but the Treasury urgently needs to rebuild its cash balance. The Treasury General Account (TGA) balance plummeted to $48.5 billion from a high of $572.6 billion on January 25 (Reuters, 2023). The Treasury will now attempt to rebuild the TGA by issuing new Treasury Bills. To meet its cash targets, the Treasury needs to issue $350 billion of Treasuries in the coming three weeks, which would mark one of the largest cash rebuilds it has undertaken on such a short horizon.
It is anticipated that most of the newly issued Treasury Bills will be purchased by money market funds. However, the Treasury needs to incentivize buyers by offering higher rates (particularly as compared to rates offered on the Reverse Repo Facility). This may have downstream consequences.
For instance, an influx of higher-yielding Treasury issuance could affect stock and bond performance (e.g., investors might sell their stocks and bonds to buy these safer T-Bills instead). Moreover, this could strain bank balance sheets (due to interest rate risk), cause more deposit flight to higher yielding alternatives, and put downward pressure on other liabilities - such as bank reserve balances - deposited at the Fed.
The Global Inflation Fight:
Global central banks currently face a critical juncture in the battle against inflation, deciding whether to pause or continue rate hikes (Aldrick, 2023). Labor markets remain robust as businesses retain workers, and pent-up pandemic savings continue to bolster consumer demand. Pausing rate hikes risks rekindling bullish equity markets, placing central banks in a difficult position.
Central banks are adopting different strategies to address this challenge, with the U.S. Federal Reserve contemplating a break from its credit-tightening campaign and the European Central Bank (ECB) likely announcing a quarter-point hike in June.
Bond Investors Worried about Recession Risk:
Despite the recent strong performance of the US economy and stocks, bond managers caution investors against complacency, asserting that the damage from 10 consecutive increases has already been inflicted (Worrachate, 2023). For instance, credit card balances have remained largely unchanged from Q4 of the previous year to Q1 (contrary to the typical trend of balance declines in Q1), suggesting that consumers are stretched thin.
Prominent bond managers predict a significant credit crunch due to central banks' tightening policies. They argue that the collapse of three US banks in March foreshadows a larger crisis. Mike Riddell, a portfolio manager at Allianz Global Investors, posits that the unprecedented pace of global policy tightening observed over the last year may result in a moderate-to-deep recession (Worrachate, 2023).
Current Outlook:
The resolution of the U.S. debt ceiling standoff, the ongoing battle against inflation by central banks, and the looming threat of a recession are all components of a larger puzzle. The risk is that higher T-Bill yields (caused by record Treasury issuance) could result in deposit flight at banks, stressing the already vulnerable community banks and regional lenders. Higher yields on "safe" investments like Treasuries may also exacerbate capital flight from stocks and bonds, impacting consumers already strained by tight credit conditions and overextended credit card balances. This could culminate in a recession later this year.
What could change the outlook?
Higher T-Bill yields could encourage banks to offer more competitive interest rates on deposits, benefiting consumers. Other metrics, such as employment rates and GDP growth, could improve later in the year, signaling a healthier economic outlook. However, these scenarios are considered low-probability events.
Bibliography:
Reuters Staff (2023, June 7). Treasury targets $425 bln June cash balance to start post-debt ceiling replenishment. Reuters. https://www.reuters.com/article/usa-treasury-cash/treasury-targets-425-bln-june-cash-balance-to-start-post-debt-ceiling-replenishment-idUSL1N37Z2HX
Aldrick, P. (2023, June 10). Fed Is First to Reach Crucial Junction in Global Inflation Fight. Bloomberg. https://www.bloomberg.com/news/articles/2023-06-10/fed-is-first-to-reach-crucial-junction-in-global-inflation-fight
Worrachate, A. (2023, June 11). Goldman’s Low US Recession Odds Get It Wrong, Bond Investors Say. Bloomberg. https://www.bloomberg.com/news/articles/2023-06-11/biggest-bond-managers-say-us-recession-is-inevitable-bucking-goldman-s-call
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