In our last piece, we discussed the added complication of US debt ceiling negotiations on the evolving global macro backdrop. While we suggested that the Republican and Democrat negotiators would likely agree a deal at the 11th hour, we also suggested that the inference of the proximity of the negotiations to a self-inflicted crisis would likely focus the attention of markets on not just the debt ceiling itself, but also the debt dynamics and absolute levels of debt in the US. More specifically, we posited the importance of the implied fiscal contraction as a function of debt ceiling compromise from the Democrat administration.

Last week, we also discussed the evolution of monetary policy projections for the Fed (as well as for the RBNZ, BoE) more specifically in relation to our views on debt, credit and inflation. This week, amid some interesting central bank commentary and some numbers on the change to the fiscal backdrop, we have some further thoughts.

Over recent weeks, markets have become increasingly confident in the US economic strength narrative, and by extension linking the more resilient economic viewpoint to stronger aggregate demand and thus more persistent inflation. This ultimately has raised question marks about the ability of the Fed to pause now and or cut later.

We remain of the view that aggregate demand is weaker than the recent data surprises suggest (and we would continue to argue that when viewed through the lens of absolute value, rather than relative moves the broader economic data remains weak). However, it is not our central view that growth collapses into something significantly more recessionary. Rather, we see the ‘release valve’ coming through the price channel with inflation falling back as supply and demand in the labour market (and global supply in goods and services markets) moves toward equilibrium.

Against this backdrop we are also of the view that the Fed have likely already done enough. A number of Fed speakers have given explicit reference to the fact that monetary policy is in “restrictive territory” of late. Furthermore, from our perspective, the recent rate repricing in the US reaches a little too far.

In essence the recent uptick in Fed rate hike expectations have come on the back of a very distorted front end rates market. This distortion comes from two separate, but linked factors. Firstly, the uncertainty over the debt ceiling induced a significant risk premium in front end TBills, as markets feared owning expiries (and to a lesser extend coupon payments) in the window of uncertainty for US Treasury finances (most acute in the 2nd week of June). This risk premium pushed front end yields higher (sharply in some specific cases), as the US data continued to hold in well relative to expectations.

Secondly, the running down of cash balances in the Treasury General Account (TGA) coincided with a halt in TBill issuance. Thus, it is likely that there will be a significant programme of bill issuance now that the debt ceiling has been lifted (formally over the next couple of days) in order to boost the TGA, and liquidity. The uncertainty comes in the debate about the implications of this issuance. It could be argued that significant issuance (estimates are in the region of USD 700 billion) should push yields higher. However, we are much more sceptical that this will be the case and continue to see front end yields as relatively rich - certainly relative to our views on forward looking inflation (real rates) and growth.

For us it is the flip side that is more interesting.

While there has been very little focus from commentators on the fiscal tightening that result from expenditure compromises in the debt ceiling negotiations - we continue to believe that they are significant in the macro debate. Expenditure will be capped at a lower level that 2022. I have seen calculations, that I have no reason to disagree with, that suggest the fiscal impact of Democrat spending concessions are in the region of 0.2% GDP, or somewhere equivalent to about 25bps in Fed policy tightening – Another headwind to the already sharply falling inflation rate in the US. On both scales, the numbers are of relatively limited consequence and purely on a relative basis perhaps understandable that these numbers have not altered the consensus debate.

However, as we have argued for many months now, markets have, from our perspective, likely been too focussed on relative changes and not the (cumulative) absolute.

It is only a few weeks ago (mid-March) that we were discussing the impact of the US small bank shock on the availability and cost of credit. At the time it was broadly agreed that the impact of the event was a tightening of credit conditions that would likely be equivalent to 25-50bps of Fed tightening.

If we sum the implications of the effective tightening of financial conditions from the credit shock and the debt ceiling fiscal contraction, then it could be argued that ‘actual’ rates are 75bps higher than what is implied by the current Fed Funds Rate (FFR). In other words, it could be argued that currently the FFR is at an effective 5.75-6.00%. In respect of the Fed Summary of Economic Projections (SEP) in December, we are significantly higher than the implied peak FFR and the path of inflation is lower than was anticipated - not consistent with further rate hike expectations.

Lastly, to put this debate in the context of real rates and the expected long run equilibrium rate - the restart of the Fed estimates of r* (abandoned in the uncertainties of the data through the pandemic) shows no change in the Fed estimate through the period at around 70bps. This is significantly below the current implied real rate and thus a further quantification that rates are clearly in restrictive territory. Sufficiently or not.

This is where we think the Fed deliberations likely lie and the rationale for the pause/skip/pace change language that we have seen this week. The decision about whether to hike further against the factors outlined above will likely not be taken lightly (not least because of the potential further implications for the banking sector and credit creation). We are of the view that they are done, but against uncertainties an extended period of data collection towards a decision once a quarter is perhaps a reasonable compromise.