Jupiter: The US government faces systemic risks

Going with the form book, both the US Federal Reserve (Fed) and the European Central Bank (ECB) raised interest rates by a quarter-point this week, now respectively at 5.25% and 3.25%.

Hups-a-daisy! Up we go. No, wait there. Down we go again!

Deep among the weeds, markets remain sensitive to, indeed perplexed about, the plethora of economic data and what to make of it. Take two cases in point this week, both on Tuesday. First, the April eurozone inflation data experienced another hiccup in its trajectory towards the European Central Bank’s 2% target; consumer prices rose by 7% year-on-year, accelerating unexpectedly again from 6.9% in March while a modest decline had been anticipated. Bond yields immediately rose in anticipation that with inflation still defying the target and particularly heading back in the wrong direction again however temporarily, the ECB would be forced to maintain its policy of raising interest rates. In the words of its President Christine Lagarde earlier this year, to slay inflation, the “monster that we need to knock on the head”.

Then, only hours later, the US job vacancies data undershot market estimates: there were 9.6m job positions open in March against 10m in February; March represented the fourth consecutive monthly decline since December’s figure of 11.2m. As importantly, the market had been expecting a higher figure too, the consensus estimate being 9.8m. Labour markets were slowing faster than anticipated. Oil prices have been weakening again despite OPEC trying to prop them up by restricting daily production by 1.2m barrels per day. Joining the dots, the logical conclusion was that the economy must be slowing faster than expected, inflation would therefore abate more rapidly and the US Federal Reserve should moderate its tone about future interest rate rises. Implying that this was of greater significance than the European inflation data, bond yields lost more in the afternoon than they had gained in the morning. Clear so far?

“It’s all Greek to me”

If markets were undecided (and remain so!) as to whether they were hostages to circumstance, blowing in the breeze of seemingly conflicting data, or were leading the witness by the nose ahead of the central banks’ policy meetings, the Fed’s accompanying statement to its interest rate rise did little to resolve their confusion. And not for the first time.

Chairman Jay Powell’s propensity to conceal his message behind a verbal smokescreen is becoming legendary. In March, he noted that “some additional policy firming may be required” and went on to allow the inference that, if not with interest rates, he would not be averse to the restraint of credit from commercial banks to the corporate sector and consumers to do the additional heavy lifting to slow economic growth. Less than six weeks later, in what he describes as a “meaningful change” to the narrative, with masterly obfuscation he now indicates that he would weigh up multiple factors in “determining the extent to which additional policy firming might be appropriate”. As if his monetary policy committee does not already weigh up multiple factors? Putting words in his mouth (and interpreting the smoke signals from central banks is often about semantics and subliminal messages), the sum of his policy leadership can be distilled down to the following: he will look at the data but really, he has no more idea of what it means for the outlook than anyone else; so he will wait and see.

But thanks to US inflation (5.0%) being half that of the UK (10.1%) and two percentage points lower than the eurozone’s (7.0%), the inference among investors is, for the Fed at least, that the peak interest rate has been reached in this tightening cycle (with the qualification of “all other things being equal”). That is not to say that quantitative tightening is completely at an end, however. The Fed is still actively reducing the size of its balance sheet, soon to be by $95bn per month, and the restraint of credit above is playing its own part.

Systemic risks remain…

If US interest rates have peaked, investors and central banks now move into the next phase of their mutual stand-off: how long should rates remain at a plateau before coming down again? It is logical that the longer they remain high, two things happen: first, it increases the risk of a hard-landing recession; second, gradually more and more debt is subject to the full elevated cost of capital (there is a natural lag effect as bonds and loans with different redemption and repayment dates are refinanced over time rather than simultaneously). That cost of servicing the outstanding debt not only creates an increasingly frictional fiscal drag at all levels of the economy, it also exposes the structural weak points in the financial system. For what it is worth, bond investors are ‘pricing in’ (i.e. guessing/hoping) that US interest rates will be between one and two percentage points lower than today by the third quarter of next year.

…in the banking sector…

As we discussed several issues ago, that restraint of credit is as much anything a result of the financial instability of an unhealthy number of US Tier 2 and Tier 3 regional banks (and some concerns over even one or two of the national Tier 1 lending banks) as potentially wobbly lending institutions seek to preserve their balance sheets.

Markets are right to remain wary. Last weekend in the US, First Republic Bank, already subject to what was supposed to have been a lifeline capital injection from a consortium of banks a month ago, failed both to stem depositors’ withdrawals and restore shareholder confidence. As the road rapidly ran out towards insolvency, the authorities effectively took control. Offering substantial state subsidies and guarantees, they engineered its immediate purchase by JP Morgan Chase. JP Morgan’s President, Jamie Dimon, promptly declared the banking crisis “over”.

Authorities and regulators had insisted until recently that the US banking system was secure. In the event, once a tipping point was reached with interest rates and their knock-on effect with bond prices and the consequential heightened awareness of the inadequacy of capital reserves to insure deposits, it took remarkably little for three Tier 2 and Tier 3 banks to fall over in the US in very short order. Credit Suisse in Europe suffered a similar fate. With the vultures once more circling over other secondary US banks, one hopes Dimon does not have cause to rue making his confident statement.

…and for the US government

The US government remains in financial special measures. Consider the significance of that statement when applied to the world’s biggest economy, 25% of global GDP, home of the world’s principal reserve currency. Regular readers of these musings will be familiar with the subject given we have been discussing it since January. That we are still discussing it in May is indicative of Biden having lost control of Congress in the November 2022 mid-term elections and his inability so far to forge a consensus on the way forward. The sand is inexorably running down the hour glass.

Having breached the $31 trillion debt ceiling set by Congress, other than to replace bonds which have expired the US Treasury finds itself unable to issue net new debt. Instead it is living off a strictly limited pool of cash held at the Fed with which to pay for ongoing government services. In political deadlock and after four months of wrangling, Congress is no closer to agreeing a new ceiling. If left unresolved, it will mean the administration is faced with the financial Judgement of Solomon, a predicament all of its own making: maintain the interest payments on government debt but stop paying for government services, and the country grinds to a halt; or, maintain services and default on the debt, in which case the government is bust.

Logic says that the government needs an injection of fiscal reality. There is a blueprint: “Reaganomics”, a stern dose of 1980s-style monetarist economic policy which at least balances the books and the country starts living within its means. It will not happen. Such a policy volte face and the implied association with the arch-Republican actor-cum-monetarist visionary Ronald Reagan would be political suicide for Joe Biden with his own party, particularly on the left. Equally unlikely (though not impossible) is that D-Day passes with no resolution and in preference to financial default, the government is forced to suspend public services; there is considerable political risk for both Republicans and Democrats seen to be behaving irresponsibly and at potentially ruinous cost to the economy. Most likely is that even if negotiations go to the wire, a new higher ceiling will be agreed and the can is kicked down the road once more; only the situation is worse because an increased proportion of government spending will be used for nothing more productive than paying the higher interest cost on the government’s debt (consider it like this: you’d be raising net new borrowing to pay for the increased interest on your existing borrowings which should never have been allowed to be so great in the first place).

The path of least resistance is the easiest. Confronting hard choices and having the bravery to see unpopular policies through is much more difficult. Just ask President Macron! Two months of national riots and arson from raising the French pension age from 62 to 64. He’ll tell you all about the political pitfalls of hard choices!

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