by Cliff Wachtel, FX Empire
Here’s an additional collection of lessons learned from the latest US debt policy battle (see here for the previous one) –
What We Got
Key details of the debt deal include:
- The bill, signed into law late Wednesday night US time, after an 11th-hour deal brokered by Senate Majority Leader Harry Reid and Minority Leader Mitch McConnell earlier Wednesday.
- It funds the federal government through Jan. 15 2014 and suspends the nation’s debt limit through Feb. 7. (For the full text of the bill, see here.) That means from January 1 to February 7, 2014 the US can continue to spend beyond the amounts agreed in this deal by selling new bonds, without risk of hitting a debt ceiling. Extraordinary measures could keep all running until sometime into mid-2014, depending on how much new debt the US sells as a means of ensuring it has cash on hand to last through another protracted negotiation. Indeed, the mere existence of a large enough reserve might be enough to discourage such a protracted battle because it will limit the ability of Republicans to again raise the insolvency or shutdown threat.
- Continued Sequestration (automatic budget cuts in specific categories of expenses)
Here are the lessons learned for next week and beyond, especially when we revisit this same issue sometime in Q1 2014 (don’t save this for reference, I’d hate to be caught re-using chunks and that would save so much time).
Back To Pre-Debt Ceiling Debate Mode
Now that the US has chosen to buy time at a cost of yet more debt, we return to prior market watching conditions.
1. Depending On Continued QE As The Only Way To Sustain The Weak US Recovery
The Fed will make its decisions based on signs of improving US growth, jobs, rising inflation. It will also, it seems, be planning ways to insure ‘stability of payments’ in case Congress threatens that again (dammit, Janet, we love you…).
That means the relevant monthly data reports on these will not necessarily be moving markets in their traditional, direct way (if good data, then risk assets and risk currencies) (AUD, NZD, CAD, EUR) up, safe haven assets and currencies (JPY, USD, CHF) moving in the opposite way and vice versa. Instead, markets will often be moving with how they think the FED will react to the data. That means:
- Very bad data is bad because QE isn’t helping, so now what do we do?
- Very good data may be seen as bad if it is believed to increase the pace and timing of a Fed reduction of bond buying (QE taper for those who have been out of touch for the past 7 months or so).
- Goldilocks data (not too hot, not too cold) is likely to get the most bullish response because markets get both hope and continued Fed support.
For a full explanation of risk/safety assets and risk currencies, see here and here. To know how to monitor them all in a matter of seconds, see here. You’ll be a much more sophisticated trader or investor once you have these topics down. For a more in-depth explanation, see here or here.
2. Scheduling Periodic Debt Debate Uncertainty
We return to living under threat of periodic budget crises, kind of like the Greeks, only ours are purely self-inflicted. We have yet another temporary US budget deal as the US is badly polarized on the wisdom of this modern day-extreme Keynesianism during a non-emergency, given:
- the risks entailed of eventual inflation and USD debasement
- the questionable benefits of QE beyond propping up risk asset prices
Uncertainty Over Next Budget Fight Remains
All understand we’ll be revisiting this crisis in early 2014. Barring new bullish surprises, that uncertainty should limit risk asset markets uptrends, and will weigh heavier at the start of 2014.
Is The US Budget Battle of 2014 Already Over?
The consensus is that the Republicans will be less confrontational next time because they were blamed for the crisis, hence the radical tea party wing was discredited, and the moderates are in control. Therefore the Republicans won’t dare try again to hold the US solvency hostage to its “outrageous” demands that the US actually cut its spending and live within its means so that it might avoid risking insolvency in the future. Therefore, per Goldman Sachs, and other sophisticates, the next fiscal battle won’t be nearly as bad. Even if they try, after having yielded twice, they can’t offer credible threats to let the US default or even shut down for an extended period.
What Mix of Tax And Spending? Washington Still Undecided
We’re not so sure it will be that simple.
You can disagree with the Republicans’ brinksmanship, but their basic position is more than reasonable. The US debt level and debt/GDP can’t rise indefinitely without taking unacceptable risks with America’s long term solvency. The Democrats have no credible plan to materially cut spending and preserve the US’s fiscal credibility, which is surviving on borrowed time, and money.
Sure, the US can always print more money. The question is how long markets will continue to buy US bonds at low rates when the USD is being debased. Obviously at some point credit markets start demanding higher yields to compensate for rising risk of being repaid in dollars that will be worth much less.
The Republicans will not change their goals, but only their methods of attaining them. They have a few months to figure out how to improve those.
It all depends on whether the Republicans can better articulate their very reasonable message that the US can’t keep deferring deficit reduction and spending cuts indefinitely, nor can it substitute spending cuts with tax increases without killing of the already weak recovery. If they can, we may yet again see turmoil.
Why US Will Continue To Experience Similar Budget Debate Crises
Polarized Electorates Yield Polarized Government: As discussed in depth here, the relatively polarized US electorate means it is likely to continue to elect a polarized legislature, at least regarding fiscal and monetary policy.
Separation of Legislation To Spend and Legislation To Fund That Spending: As noted by the Standard and Poor’s Ratings Committee Chairman here, the US debt ceiling crises arise because Congress can (and does) authorize spending without authorizing funding for that spending at the same time.
“We have a budget system that’s unlike any other budget system that I’m familiar with. We have spending and revenue measures that have originated from an original act in Congress. Now it’s a question of funding them. The spending has already been approved, but now the elected officials are balking at funding that spending.”
Majority Of US Spending Not Even Subject To Debate/Congress Ignores Non-Discretionary Spending: For all the noise about budget debates, the actual portion of the US budget that is even being debated is only a relatively small percentage of annual spending. As reported by Citibank here, the majority of US spending, mandatory programs like welfare and health care, never come up for debate and so Congress has yet to even seriously address material spending cuts.
Must Know Lessons From The US Budget Battle For Next Time
02 oct 18 1648
In other words Congress and the president are not even planning on putting the country on a path to long-term fiscal sustainability, because they aren’t discussing entitlement and tax reform. Why?
Politicians fear voters as a whole won’t vote for those who cut their entitlements, nor will they vote for those who impose higher taxes needed to keep those entitlements. It’s kind of like being a parent, but here the kids have the power to kick you out of the house unless you explain things really well and can offer them some treats you can actually afford.
Bullish: Taper Deferred
The consensus is that the combination of a new, more dovish Fed Chairperson, continued weak US growth, and the new economic damage incurred by the latest shutdown and threat of yet another in early 2014 will prevent the Fed from cutting back on QE3. Jeff Gundlach, the reigning leading bond authority, claims that US interest rates will stay low for the foreseeable future, as the economy is now beyond doubt too weak to absorb higher interest rates. Gundlach has argued, ever since the news of a possible taper hit, that the US economy was too weak to continue growing if rates rose.
Good for risk assets – stocks, industrial commodities, higher yielding currencies like the NZD, AUD, and CAD – bad for safe-haven assets like investment grade bonds, the USD and JPY. With tepid earnings and economic data, QE has been the prime support for risk asset prices. The belief that QE will be around longer is therefore supportive of risk asset prices, and bearish for safe haven assets. It is especially bad for the safe-haven USD (and all those who get hurt by its loss of purchasing power – ultimately most of America’s citizens and investors in US assets), which now continues a march of unknown duration towards further debasement and risk of inflation once the economy actually does recover and money starts circulating at a faster rate. Anyone unfamiliar with the above terms and their meaning should refer to the links in this paragraph.
Of course the Fed has assured us it has the tools to contain inflation risks. However we all know that an expansion of debt and liquidity of this magnitude has not occurred within the working lifetimes of those running the Fed. So even if they think they’ve the tools, what makes them think they know how to use them?
Does The Fed Have A Choice?
Given the Fed’s dual mandates of price stability and jobs growth, and probably a third mandate (as expressed by Janet Yellin) to ensure stability or US payments for its obligations (as pointed out by Cullen Roche, see here for details).
Per Keynesian theory, the reigning economic ideology in Washington, when the private sector is weak it’s the governments job to step in and keep the money and jobs flowing. Nor is the public sector alone. As CNBC points out here, US companies and consumers are embracing higher debt:
- Consumer credit of $3.04 trillion as of Q2, +22% over past three years
- Student loans +66% over past three years
- Total household debt is $13 trillion, almost back to 2007 peak
- Government debt almost $15 trillion
- Through September junk bond issuance is a record $372B, +27% y/y
- US loan volume is $1.53 trillion through Q3. +25% y/y
- Globally, syndicated marketed loans hit $2.93 trillion Q3, +15% annualized gain
- High-risk leveraged loans global volume hit $1.23 trillion, highest since 2007″
However, not only we not getting much marginal growth for this plethora of debt (current GDP at pre-recessionary ~1.5 – 2%), we have no idea how we’re going withdraw for the debt addiction without crashing the markets, as was threatened with this summer’s “taper tantrum.”
See our additional posts on lessons for the coming week and key market movers to watch.
DISCLOSURE /DISCLAIMER: THE ABOVE IS FOR INFORMATIONAL PURPOSES ONLY, RESPONSIBILITY FOR ALL TRADING DECISIONS LIES SOLELY WITH THE READER. IF WE REALLY KNEW WHAT WOULD HAPPEN, WE WOULDN’T BE TELLING YOU FOR FREE, NOW WOULD WE.