We wait for next week’s Fed meeting, with another 25bp rate hike expected by the market, which will take the Fed’s target rate to 5%-5.25%. It is likely to be the last in the cycle, although market expectations of rate cuts from the autumn may prove premature.
Meanwhile, the U.S. government debt market, which has been volatile this year, continues to display peculiarities. The inversion on the yield curve has been discussed at length. What is new is the growing spread at the very short end, between 1 and 3-months, which is now 1.2%. The 4-month yield is still higher. This is not accounted for by expectations of a rate hike on May 3.
A better explanation is politics, namely the coming fight over the federal budget deficit ceiling. It is a perfect example of political instability being reflected in financial markets and it matters to investors and adds to the already quite full bucket of risks that investors must take on board over the coming months.
Judging by past deficit ceiling crisis, the risk of default on government debt is low. But it is increasing, with the Treasury now expected to run out of cash between late June and late July, following disappointing tax receipts and a political log jam in Washington that makes compromise difficult.
The result is that it is 3 and 4-month Treasury bills that appear most at risk of default, which explains the growing hump at the short end of the curve, as investors demand risk premia on those maturities.
Source: US Treasury Yield Curve.com (US Treasury Yield Curve) as of 4/19/2023
The 3-month yield of 5.2% stands in sharp contrast to the 4% on the 1-month, and 3.6% on the 10-year Treasury. Meanwhile, the inversion at the middle and long-end of the curve shows no sign of letting up, the gap between 10yr Treasury and 3-month T-bill yields have been negative since last October and is currently at the most extreme levels since the St. Louis Fed began tracking the spread in 1982 (at -1.57%). A sure predictor of recession, according to many analysts.
Why does the debt ceiling matter?
Investors need to be mindful of the potential impact on the U.S. economy of a sudden fall in government spending and a pickup in precautionary household savings, should the federal government find itself with a cash shortfall. Both of which could aggravate an already slowing economy, potential bringing forward the start of the mild recession that many economists anticipate and/or making it worse.
And as the increase in T-bill yields shows, bond investors are nervous of the risk of default on interest and capital repayments. But the risk will also be reflected in higher yields (and weaker prices) on U.S. commercial lending, which is priced off what the government pays. Higher commercial lending rates will contribute to tighter monetary conditions.
Furthermore, Treasury and T-bill yields are used as the risk-free rates of return for calculating asset valuations around the world. A rise in any part of the U.S. yield curve negatively impacts on the investment case of assets of a similar duration.
We may see a response from the Fed, in the form of buying T-bills at the hump of the curve, in order to reduce the impact of the crisis on financial markets. It may do this liquidity injection in the name of financial stability, whilst simultaneously engaging in quantitative tightening in the longer-dated Treasury market. This is what it did during the bank crisis in March.
As we mentioned a few weeks ago, there will be a winner from the ratcheting up of yields on paper due to mature over the coming months. Money market funds, which invest in short-dated government and commercial paper, will be able to offer depositors relatively eye-watering savings rates. Their bank competitors will have to make do with the much lower yields available from long-term debt, and the flow of deposits from banks to money market funds looks set to persist.
Why the impasse?
The first (modern) debt ceiling crisis was in 2011, under President Obama, when Republicans demurred at increasing public borrowing, at the behest of the Tea Party. The crisis was eventually solved, but U.S. debt lost its triple-A rating. The Democrats then waved through increases in the debt ceiling under President Trump, but Republicans have found it hard to return the favour, again stating ideologically commitments to a smaller state and hostility to specific social programs.
The room for manoeuvre is small. Kevin McCarthy, Speaker of the House, is obliged to negotiate spending cuts in return for increasing the debt ceiling. This is a promise he made to the Freedom Caucus in January, as a condition for their votes. The Republican party is itself split between die-hards and realists.
Meanwhile, the Democrats refuse to negotiate, with President Biden sensing that the issue will backfire on the Republican Party if the Federal government stops paying wages and if investors flee short-dated government bonds. Many Republican voters are happy recipients of the very social welfare programs that the Republicans wish to trim.
The Democrats also have a fundamental argument on their side, which is that Congress has already passed the budget that determines the necessary spending and borrowing. Indeed, no other major country requires effectively a second confirmatory vote on the government budget from the same body that previously agreed it. But there is little chance of the law being clarified.
And the law is as clear as it is ambiguous. The Liberty Bond Act of 1917 established the principle of curbs on U.S. Federal government borrowing, but it runs counter to the 14th Amendment to the U.S. Constitution of 1868 that states that ‘the validity of the public debt of the United States…shall not be questioned’.
Long-term investors are best served by a broad, multi-asset approach to investing that includes equities, bonds and alternative asset classes. These are often found in multi-asset funds. Financial history shows persistent outperformance, in terms of returns per unit of risk, from such an approach.
The debt ceiling may contribute to bond and stock market volatility this summer. As if there is not enough uncertainty around!
Ready to find out more?
At Brite Advisors USA, we work with UK ex-pats all over the USA on their investment needs, both retirement and non-retirement. Our US-based advisory team seeks to provide an outstanding experience for all clients.
We facilitate UK pension transfers using UK Self-Invested Personal Pension Plans (“SIPP”) provided by UK-regulated pension trustees for clients who want to save for their retirement by taking advantage of potential stock market growth.
Contact us today to find out more.
- No Investment Advice: This financial commentary is for informational purposes only and is not intended to be, and should not be, construed as an offer to sell or a solicitation of an offer to buy any security or financial instrument or invest in any equity or investment strategy. It should not be used to form the basis of any investment decision. Charts used are for illustrative purposes only and should not be used to form the basis of any investment decision.
- Investment Risks: There are risks associated with investing in securities and past performance is not indicative of future results. Always seek professional advice before investing.
- Not Legal/Tax Advice: This financial commentary is not intended to be, and should not be construed as, legal, regulatory, tax, or accounting advice. Always seek professional advice and consult with your legal counsel, tax and accounting advisors when contemplating any course of action.