Debt Deal & Observations
What happened last week?
The announced debt agreement would suspend the $31.4T debt ceiling until January 1, 2025, after the 2024 elections. Defense spending would increase 3% in 2024 while non-defense discretionary spending holds steady; both then increase by 1% in 2025.
Work requirements for some on food stamps would go up from 49 to 54 years of age. Some IRS funding would be shifted.
Roughly $30B in unspent Covid relief would be clawed back and plans to end a student loan payment pause in August would be honored.
3 Things to Know
A different type of recession
In 2023, the industries that signal recessions are contracting and new sources of restraint are building.
Tighter bank lending standards will lead to a deeper slump in commercial real estate investment. For the same reason, entrepreneurs will find it significantly more difficult to finance start up enterprises that are not quickly profitable.
Layoff announcements in the IT sector have already surged. These are normal elements of typical recessions. Then, there are unusual economic events.
Consumer services spending is growing solidly (though less rapidly) in recent months, whereas residential construction spending has collapsed 19% over the year through 1Q 2023. The travel and leisure industries can’t get enough employees while technology related businesses are seeing layoffs.
Major stock indices have risen, but most stocks are flat to down on the year. This is atypical. It appears that contracting industries are beginning to make progress in reducing inventories.
As inventories fall early in a recessionary cycle, it provides fuel for an eventual recovery. The situation is indicative of a rolling recession for the US economy.
The employment head-fake
US employment dropped by a record amount in 2020 and the economy recovered rapidly that year, but many employers could not find basic labor.
Many firms in 2023 are still hoarding labor as a result. You can see this in the data.
Over the past year, demand ebbed and worker output fell 1%, yet total hours worked by new and existing employees rose 2.3% over the same period.
This has resulted in falling productivity and weaker corporate profits. On the other hand, this has sustained real personal income and spending gains, more so as inflation has fallen. This, in turn, will help cyclical industries work off inventories, mitigating their future impact once services spending slows.
The absence of a major downturn in employment and the offsetting economic impacts of the rolling recession might result in another, more dangerous round of tightening financial conditions.
This is when the current threat of US default ends with an agreement to raise or suspend the debt ceiling, enabling the US Treasury to borrow again.
When the US Treasury borrows again
What happens after any debt ceiling agreement is reached? Unlike 2011, when US equity markets fell by 15% after a debt ceiling agreement was reached, the present bearish positioning of investors suggests markets will likely see at least a short relief rally when a deal is struck.
There’s more cash on the sidelines, in bank deposits, Treasury bills and money market funds than ever before. Shortly after an agreement, the Treasury will issue an enormous amount of T-bills to replenish its cash balance.
Within a month, the supply of 1–12 month bills should swell by at least $300 billion in addition to normal redemption/issuance.
Overall, net US Treasury borrowing by the end of 3Q 2023 is likely to be about $1.3 trillion. This has the potential to generate outflows from other asset classes — including bank deposits — given that these bills will, on average, yield north of 5%.
This could put pressure on weaker banks as their deposit rates can’t easily compete with Treasury yields and money funds.