Jupiter Merlin Weekly: The US government faces systemic risks
Interest rates in the US may have peaked but, with the US government facing ongoing systemic risks, what might the future hold? The Jupiter Merlin team give their view.
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?
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.
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.
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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