U.S. Debt Ceiling Looms Over Markets
U.S. equity markets have seesawed in recent trading as investors grapple with renewed woes in the regional banking sector. Over the weekend First Republic Bank was seized by U.S. regulators and is being taken over by JPMorgan Chase. First Republic was the latest bank to fall, bringing the total assets of the 3 U.S. bank failures in the last two months to $548 billion and mark the 2nd, 3rd and 4th largest bank failures in U.S. history. According to the U.S. Federal Reserve Board, in 2022, small/midsize banks accounted for roughly 30% of new credit to U.S. companies and households. That source of funds is likely to moderate meaningfully as small banks shift focus toward managing liquidity amidst a wave of deposit outflows. Larger banks are unlikely to pick up the slack in smaller-scale, potentially riskier small business lending. As a result, the significant tightening of credit conditions we are witnessing in the wake of these failures increases the overall risk and magnitude of a recession.
As if this weren’t enough for markets to fret over, the next item to preoccupy markets is the U.S. debt ceiling. Congress is currently mired in political gridlock as we move toward “X-Day”- the day when the ceiling is reached and the Treasury is no longer able to pay its obligations. Less taxes collected by the U.S. government than expected brings forward this “X-Day,” leaving less time to reach a deal to raise the ceiling. With April tax receipts 25% lower than their five-year average, Goldman Sachs estimates that “X-Day” could occur as soon as early June.
What the Fed chooses to do in this environment going forward is the key question with a mix of elevated employment costs, stubbornly high inflation, and slowing growth clouding the horizon. The Employment Cost Index release showed annual wage growth running close to 5%. U.S. PCE data showed prices remain elevated. This underscores the dilemma the Fed continues to face. Lagged economic effects of tighter central bank policy are beginning to trickle in, but any eventual easing of policy will require inflation to decline further. Central banks sowed the seeds of the distress in the financial sector, and the front end of the yield curve is sending a clear message to Fed Chair Powell that they will be unable to keep rates at their peak for long.
Any actions by the Fed to normalize policy will hinge on how the trade-off between financial stability and inflation risks evolve. Given sticky inflation and exorbitant levels of government debt, any additional bank stress and rising recessionary risks are unlikely to be met with another large fiscal response. Disappointing GDP and hot PCE inflation figures have brought stagflation fears to the forefront. Higher inflation typically implies a weaker currency over time, but the current backdrop could be supportive of the U.S. Dollar in the medium term. The Fed may be deterred from cutting rates as soon as the market expects which would be a net positive for the dollar. These fears of slowing growth can also be seen in copper, which is off over 8% from its recent high and is largely viewed as reliable proxy of economic growth.
As expected, the Fed raised the benchmark rate 0.25% today and are not signaling any more hikes. They appear cognizant of the impact of tighter credit conditions on the broader economy. The debt ceiling standoff could change market conditions significantly, and it appears that equity market hopes for a Fed pivot due to a soft landing in 2023 are premature. How long the Fed can keep rates in restrictive territory remains to be seen. Given the current backdrop, we remain cautious and seek high quality, liquid investments.
Ryan Babeuf, CFA
Market Strategist
Ryan.Babeuf@EdgeWealth.com
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