America’s Credit & Credibility

For those of you who would prefer to listen:

The United States hit a ceiling in which further borrowing is no longer permissible. It can borrow no more. Defaulting on its debt is officially possible. Formal notice was given to Congress by the Secretary of the Treasury. She estimates we have until June to address it before crisis sets in. 

Chances are, you already knew that. Such an event tends to grab headlines. This is no small deal. Congress is playing with fire again. They’re jeopardizing America’s credit and credibility. That’s not new. Nothing is shocking these days. That said, the Market is showing little sign of stress or concern right now. It’s still early.

“Extraordinary measures” are now being used by the Treasury Department in order to buy time to June. Although the crisis is still likely 6 months away, concerns about whether and when a deeply divided Congress will come to a deal to raise the debt ceiling will be a critical and growing issue for the global financial system. 

Importantly, the Market hasn’t even flinched. Treasuries have done nothing but rally in this young year. Stocks have rallied too. The Bond Market does not seem phased by the debt ceiling drama; At least for now.

Our Washington sources remind us that Treasury always pushes the worst-case scenario as a scare tactic to get Congress to move. “The long lead time between now and June provides an opportunity for theatrics.” They believe the White House is not likely to engage on the subject until after April 15th, when a surplus of tax revenues flow into the Federal coffers.

It’s important to point out that facing a debt ceiling is nothing new on Capitol Hill. Congress has raised the limit over 75 times since 1960. It used to be fairly routine. But the political hostility of this 21st century has made it one of the most contentiously partisan issues that Congress faces. This year might top them all. 

Subsequently, using “extraordinary measures” is not new either. The Treasury Department has been forced to use these creative maneuvers over a dozen times in debt ceiling battles. That included such steps as suspending new investments in retirement plans for government employees. In such an event, those retirement plans would be made whole again once the debt ceiling was resolved. But that’s a dangerous precedent.

Congress has a track record of creating self-inflicted crises. The debt limit tops that list. Senate Minority Leader Mitch McConnell was adamant when he said the US will not default on its debt. Those are comforting words. But the Republican Senator from Kentucky has less power and influence today. It’s beyond ridiculous that this is even a thing, but these are the 2020s. When it comes to politics, apparently anything goes.

Compromise continues to be considered a 4-letter word in Washington. Republicans are saying that they won’t agree to a debt limit increase unless it is paired with spending cuts. Democrats, including the White House, say that they will only support a “clean” debt limit increase, with no strings attached. Something has to give to avoid a crisis. It’s no wonder that those in Washington get low marks from the American people.

Rumors circulated heading into the weekend that the House GOP leadership is considering a short-term extension of the debt ceiling out to September 30th to build in more time to negotiate. This would also link the debt ceiling to the government-funding deadline at fiscal year-end. It remains unclear whether this proposal would even have enough support within the thin House Republican majority. Our sources say the Democrats are still refusing to negotiate on spending and are still pushing for a “clean” debt-limit raise.

So what are the implications? If the extraordinary measures are exhausted and Congress fails to raise the $31.4 Trillion debt ceiling, America’s borrowing costs would immediately increase. Bond yields would spike, reflecting the risk of a default, as preposterous as that sounds. We, the American people, would see our borrowing costs increase as well.

It goes without saying that a failure to make payments to meet existing obligations would cause a recession and risk a global financial crisis. The Stock Market would fall. A default would absolutely undermine the role of the Dollar as the reserve currency, relied on for an estimated 90% of daily transactions all over the world.

Here’s the thing: The whole global financial system is dependent on the United States Dollar being the universal currency and Treasuries behaving like the risk-free asset perceived. The system simply won’t work without it.

For perspective, the United States accounts for 4% of the global population but 24% of Global GDP and 60% of the Global Stock Market. The Dollar is a key factor. It plays the critical role as the risk-free currency. When the Global Economy is expanding and the investment backdrop is Bullish, investors tend to sell Dollars to buy riskier assets. The opposite is true too. That could get tested and next to nobody wants to experience a failure.

The closest the United States has ever come to defaulting was in the Summer of 2011. Market volatility spiked as the deadline drew closer. Standard & Poor’s downgraded the US credit rating for the first time ever. The Stock Market fell 19%. Congress eventually reached a compromise in early August, raising the debt limit just days before the country would have defaulted. Importantly, both Treasuries and the US Dollar rallied. That was the Market sending the clear signal that America was still home to the risk-free asset. That said, this Congress in 2023 appears even more polarized than it was 12 years ago. That sure is saying something.

There’s no getting around this: America has a debt problem. And it’s not slowing. Our national debt exploded in response to Covid. It was already a large $22 Trillion before. US debt cleared $31 Trillion last year for the first time and it kept climbing. With the rise in interest rates, the cost of serving the debt is now approaching a whopping $800 Billion. You heard that right, our nation is paying nearly $800 Billion in annual interest payments alone.

The American people have a debt problem too. There is now over $1 Trillion in credit card debt. That’s a record high. Only half of Americans pay it off monthly. It’s also amongst the worst kind of debt. Credit cards come with interest payments pushing 20%. It’s an easy trap to fall into and extremely tough to dig out. Capital One just said delinquency rates are approaching 4%. The biggest increase in missed payments came from 18 to 29-year-olds, whose 90-plus day delinquency rate rose to over 6%. 

Our Washington sources believe the debt limit debate will continue to receive outsized attention because the divided Congress will likely do little to remedy this issue before June. We can count on these risks being amplified on a daily basis because the media is obsessed with divisive political issues. “Both sides will engage in brinksmanship between now and June to bolster their negotiating leverage by trying to sway public opinion. History suggests that in the end, it seems both sides will come together to agree to avert a default since neither wants to risk receiving the blame for it.”

Importantly, America has AAA credit. It is the foundation of the global financial system. The real issue is, based on recent surveys of how the people feel about Congress, America doesn’t seem to have a AAA government in place. Playing with America’s credit and credibility is reckless and irresponsible. A downgrade would still leave a very solid investment-grade credit. But the symbolism is undeniable.

We learned this week that America’s Economy grew at a 2.9% clip last Fall. It’s solid growth that beat Street expectations. The problem is, that’s in the rearview mirror. What’s ahead looks slower. With GDP of $26 Trillion, we owe 20% more than we produce. And growth is slowing. Something’s gotta give. 

Back to the Market: The new year rally has been impressive. It’s a complete reversal from 2022. The stuff that got beat up the worst last year has so far led the January lift. That said, it’s not convincing that the worst is over for this Bear cycle. It’s more like a mean reversion in our work. But it sure has been nice to see the green.

The Fed meets next week with a 1/4-point hike already priced in. Another is expected in the Spring. The Market also believes that actual rate cuts are coming later in the year in response to the economic slowdown. But with unemployment still at 5-decade lows and risks of higher inflation still present, it’s hard to imagine the Fed doing anything other than keeping rates at elevated levels.

The Fed and the Markets are locked in with conviction. They’re clearly not all in agreement. The Fed sees a soft-landing, with a deep recession avoided. The Bond Market thinks the Fed goes too far, that recession is already inevitable and they make it worse. Equity Markets are straddling both and with the recent rally, are pricing in more of a soft-landing scenario. It hasn’t paid to fight the Fed. But Market forces are almighty. Keep those belts buckled. The Bull-Bear brawl ain’t over.

Have a nice weekend. We’ll be back, dark and early on Monday.


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