With the worst-case scenario of default in the rearview mirror, what comes next? Market attention has already moved on to focus on the stellar May jobs report and how that would affect the Fed’s upcoming rate decision. But the debt ceiling deal does have broader economic and market implications.
Fiscal tightening: headwind or welcome step?
CBO estimates that the debt ceiling deal will reduce the budget deficit by USD 69bn in the fiscal year starting on 1 October. That’s less than 0.3% of GDP. While, there has been some anxiety that a cap on federal spending would add another headwind to the economy, several factors will help to limit negative impact on growth, in our view. First, with the economy running near full capacity, the fiscal multiplier effect should be relatively small. For example, if the government hires fewer workers, that leaves more workers to fill the openings in the private sector. Second, the deal leaves open the possibility of increasing spending later if needed, for example to deal with natural disasters or unanticipated military expenditures. Third, even after this deal, the government is expected to continue running very large budget deficits.
While the merits of the details are open to debate, in our view the move toward deficit reduction is welcome. Public finances are clearly on an unsustainable path, and the time to tighten fiscal policy is when the economy is strong as is the case now, not when a recession causes the deficit to explode. In fact, we would argue that action should have been take sooner, which might have helped to slow the economy down and reduce inflationary pressure. By relying entirely on Fed rate hikes to bring inflation down, the interest cost of servicing government debt will be that much higher. With fiscal and monetary policy now working in tandem, the Fed now has a little more help on the inflation front.
Markets move on to Phase II
With the passing of the debt ceiling deal, yields of short-term Treasury bills have dropped as investors breathed a collective sigh of relief. The yield on the 6 June T-bill, which is closest to the date the Treasury said the government would run out of money to pay its bills, has dropped from 7% a week ago to 5% levels on Friday. That said, the volatility in the T-bill market is not yet fully behind us. Over the next few months, the market will focus on phase two of the debt ceiling rebuilding and repaying. The Treasury cash account had dropped to USD 38 billion last week. With the debt ceiling lifted, the Treasury can now begin replenishing the cash account to a more comfortable level—expected to reach around USD 600–700bn by year-end, while simultaneously financing the US deficit. These funds will be raised by issuing large amounts of T-bills, estimated to hit approximately USD 1tr by year-end. Moreover, the bulk of this issuance is expected in the third quarter alone. This could have the effect of draining liquidity from the market and could potentially increase short-term funding rates. In 2019, T-bill issuance had an adverse impact on liquidity and bank reserves, forcing the Fed to end its quantitative tightening program earlier than expected.
In today’s environment, given the amount of fiscal and monetary liquidity injected into the markets during COVID, we believe reserves are ample. We do anticipate a rise in short-term T-bill yields due to increased supply. However, this increase in yield should be followed by solid demand from money market funds who will be able to shift away from using the Fed’s reverse repo facility to earn yield. This balance should keep bank reserves ample and funding markets should not see significant headwinds. If in fact unexpected volatility should occur, the Treasury department can extend the timing of issuance or the Fed may increase liquidity by ending their quantitative tightening program earlier than projected.
What does this mean for markets?
The big risk from both an economic and market liquidity perspective is if the Fed hikes more than currently priced in. For a while, the market was convinced that the Fed will soon pivot to rate cuts. But the strength of recent economic data, including the latest jobs report, has once again led to a repricing of rate expectations. With inflation far above the Fed's target, there will be pressure to hike rates again at the upcoming FOMC meeting on 13/14 June. The decision could come down to the CPI data that will be released on the first day of the meeting. With the Fed's credibility on inflation at stake, a strong price increase would make it more difficult to skip a hike in June. Further, even if the Fed ends up leaving policy unchanged, we would expect them to send a clear message to markets that further rate hikes are still likely.
Main contributors: Solita Marcelli, Leslie Falconio, Brian Rose
Content is a product of the Chief Investment Office (CIO).
Original report - After debt ceiling deal, what lies ahead for markets , 5 June 2023.
