Budget and Debt Ceiling Standoffs Add Risk to Deepening Sell Off

US

Key Points

• I expect the Fed to refrain from surprising markets this week to minimize the market impact of the taper.
• The likely unravelling of the administration’s fiscal policy, together with debt ceiling brinkmanship, creates risks of a deepening market selloff.

Fed
I expect the Fed to refrain from surprising markets this week as taper by end-year has already been agreed among FOMC members and the Fed is now focusing on implementing it with as little market impact as feasible. In addition, disinflation is proceeding as the Fed expected, though Chair Powell will stress that the Fed remains vigilant on inflation risks. Specifically, my FOMC meeting expectations are:

Statement: stronger language around taper, for instance stating that the inflation condition has been met and the employment condition is expected to be met by end-year; possible acknowledgement of recently more mixed economic data.

SEP: 2021 projections MTM’ed i.e. higher PCE, core PCE and unemployment, lower GDP; 2022-23 projections roughly unchanged; 2024 projections to be closer to LT than 2023 i.e. lower GDP growth, PCE and core PCE, higher unemployment and median Fed Funds 50bp higher relative to 2023; LT: no change.

Following the FOMC meeting, Mester and Williams will participate in public events and Bowman, Clarida, and Powell will host a Fed listens event.

Data
There were a few positive data surprises this week but these did not change my conviction that the economic slowdown already underway is set to get deeper, please see my daily comments for details.

This week there are only a few important data releases. The most important one will be Wednesday’s Markit PMIs, where I expect a negative surprise. The manufacturing Markit PMI has yet to fully reflect the peak registered in the ISM survey. The slowdown in the ISM survey in turn reflects falling real goods consumption and flatlining capex. I also expect the services Markit PMI to continue to trend down, in line with the broadening economic slowdown.

Other key data include:

• Unemployment claims where I agree with the consensus on lower claims though more due to expiration of benefits and reluctance to fire workers when hiring is difficult, rather than due to a strengthening labour market.
• Flow of funds data: I will be testing my view that investment demand for money remains high and therefore that M2 balances are unlikely to be spent and fuel inflation. I will also be looking at changes in households and corporate leverage.
• Real estate market where I agree with the consensus forecast that implies a continued cooling off.
• Chicago Fed National activity index; current account balance; Leading index; and Kansas City Fed manufacturing activity index.

Covid news continued to broadly improve this week. Test positivity and hospitalizations fell, especially in red states (Charts 1 and 3). Overall immunizations continued to increase at a weekly pace of about 1.5% of the population.

As expected, the rebound in TSA passenger throughout did not last beyond the labour day weekend. Google mobility indicators slowed further (Chart 2). I expect the slowdown in mobility indicators to continue despite the decline in hospitalizations because I believe the former reflects the end of catchup demand for holidays goods and services and broadening demand weaknesses more than the impact of the delta variant.

Events/Political developments
The unravelling of the administration fiscal plans, and debt ceiling brinkmanship are coming to a head this week, which could see a deepening of the market sell off.

The unravelling of bipartisan and reconciliation packages is likely because this week the Democratic leadership won’t be able to postpone the progressive/centrist confrontation as:

1. Speaker Pelosi has agreed with centrist House democrats to put the BIF (Bipartisan Infrastructure Package) to a vote by 27 September (the BIF has already been voted in the Senate).
2. Speaker Pelosi has further agreed with centrists House democrats to only bring to the floor a reconciliation package (a.k.a. the social package) that could get the 50 Senate votes which in practice means a much smaller package, if any, than the $3.5tn announced by the White House.
3. Progressive House democrats have vowed to block the BIF if the full $3.5tn reconciliation package is not brought to a floor vote at the same time.
4. Centrist Senators Manchin and Sinema, who hold a de facto veto on the reconciliation package, are not on board with the full $3.5tn and possibly not with any substantial new spending in the short term. They met with President Biden on Friday but there is no sign an agreement has been found yet. I continue to think that Senator Manchin means to implement the pause on large scale spending he advocated in his WSJ column.
5. President Biden’s sliding approval ratings, as well as disagreement on policy priorities among the democratic leadership, are weakening the ability of the leadership to get centrists and progressive Democrats to agree to a compromise.

The most likely scenario for this week is that Speaker Pelosi won’t be able to find the votes for either BIF or reconciliation packages and will postpone those.

In addition, government funding and debt ceiling are likely to go through some brinkmanship. Funding the government before the end of the fiscal year on 30 September requires Congress to vote a Continuing Resolution (stopgap resolution that extends current levels of spending and revenues) that GOP leadership said they would support, provided it was ‘clean’ i.e. did not contain new spending or revenue measures.

But the most important budget policy development this week is the debt ceiling that can either be suspended which requires Senate Republican support (to avoid a filibuster) or raised which can be done through reconciliation i.e. without Senate Republican support.

Right now, the reconciliation instructions do not include a debt ceiling increase. Senate Democrats have announced that they would package a debt ceiling suspension with the CR in a single bill to put maximum pressure on the GOP to either support a debt ceiling suspension or risk a government shutdown. Republicans have warned that they would not vote for a debt ceiling suspension, even if it means shutting down the government.

The most likely scenario is that next week Senate Democrats will put to a vote a bill with the CR and the debt ceiling suspension that will get filibustered by the Republicans. Both parties will then try to shift the blame on the other side.

I expect that it will be the Democrats who eventually concede as they hold the majority in Congress and stand to bear the responsibility for government shutdown and default risks. The Republicans have also made clear that they will not oppose a clean CR, which shifts the responsibility for any government shutdown on the Democrats. I therefore expect the Democrats to relent and put a clean CR to the vote and the Republicans to refrain from filibuster. However, given the brinkmanship on both sides, a clean CR likely won’t be put to the vote until close to 30 September i.e. the end of the fiscal year.

I also expect the Democrats to relent on the debt ceiling and raise it through reconciliation. Reconciliation can be used once a fiscal year each for revenues, expenditures and debt ceiling increases. Moving the debt ceiling to reconciliation however will take some time as new reconciliation instructions will need to be issued; and procedures provide a limited time for debate. In addition, there will be significant political costs involved for the democrats since the increase in the debt ceiling will be substantial: the Democrats are likely to cover funding until after the November 2022 elections i.e., August 2021- September 2023. The CBO estimates of the FY2022-23 deficits is $1.9tn. As a result, I expect the debt ceiling increase to be passed after the CR and closer to the Treasury running out of funds, which Secretary Yellen has indicated could be sometime in October.

Like any form of brinkmanship, the scenario I am describing is not without risks, for instance linked to each party misunderstanding the other side reaction function. In addition, there may be a need for external pressure, for instance a sharp market selloff, to get one or both parties to concede.

That said I believe the current situation is fundamentally different from 2011, when the US was downgraded by the S&P due to its failure to raise the debt ceiling. The difference is that this time around the Democrats control both chambers of Congress, which gives them the power to end the stalemate as well as the incentive to do so, lest they be held accountable for government shutdown and default. A test of my view will be the FOMC meeting: Chair Powell is very clued in with the Washington political establishment and will have a good insider view of the likely resolution. If the FOMC ignores the budget standoffs and proceeds with a taper announcement (as I expect), it will signal that it expects a resolution without lasting consequences for markets or economy.

That said, this fiscal brinkmanship is complex and market participants could be negatively surprised. Against a backdrop of growing risks of systemic financial crisis in China, as well as rising US growth pessimism (see e.g. JFRIUS index), the implosion of the administration fiscal policy and the debt ceiling brinkmanship could see a deepening of the market selloff this week.

Links to New York Fed POMOs/TOMOs: Repos, Treasury, MBS, CMBS

G20

This week the BoJ and BoE are meeting and are expected to keep policy unchanged. The RBA is publishing its minutes. The ECB’s Schnabel and Guindos, and the RBA’s Bullock are speaking.

Key data this week include PMIs in Australia, France, Germany, the Euro area, the UK, and Japan as well as Japan’s CPI and Germany’s IFO survey.

Links to BOJ Rinban , BOE OMO

COVID-19 Monitoring

Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed , the IMF and the World Bank. She publishes the blog Macro Sis that discusses the drivers of macro returns.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)