Oscar Pulido: Welcome to The Bid, where we break down what’s happening in the markets and explore the forces changing the economy and finance. I’m your host, Oscar Pulido. Today is Thursday, June 1st.
The debt ceiling has been capturing headlines for weeks now. And the recent vote in US Congress has drawn a line under the drama in Capitol Hill for the next two years. But what does this mean for markets and are investors feeling reassured?
In this special episode of The Bid, I’ll be speaking to Alex Brazier, Deputy Head of the BlackRock Investment Institute to look at what happened, how markets are reacting, and what investors can expect going forward now that the debt ceiling crisis is behind us.
Alex, thank you so much for joining us on The Bid.
Alex Brazier: Oscar, thanks very much for having me again.
Oscar Pulido: So, Alex, we’re talking about the debt ceiling, which has been in the headlines for some time now, and I wonder if you can just take a step back and fill us in around what has happened and where are we now?
Alex Brazier: Well, yeah, it’s been front and center for the last few weeks really what happened is that the US government reached its debt ceiling, which is a level of debt set by Congress that it can’t go beyond, and that limit was $31.4 trillion. And given the US government’s spending and tax plans, it needed that to be lifted. But of course, its opponents wanted it to change its plans in return for lifting the ceiling. Now, importantly, without an agreement, US government would’ve basically run out of money to pay its bills. The US Treasury estimated that it would’ve run out of money on the 5th of June, so that would obviously have been hugely disruptive, both for the economy directly, but also for the financial system with the US government unable to pay interest on or make scheduled repayments on existing debt.
It would’ve been in default. And that’s absolutely critical because the financial system relies on the US government and its securities as ultra-safe, reliable assets, hence the real focus on all these negotiations in Congress. But now, an agreement has been reached at the 11th hour, and it’s been passed by the US Congress.
Now the debt ceiling limit has been suspended until 2025. And in return for that, the US government has moderated some of its spending plans. That means markets are breathing a sigh of relief now. But that just means really attention is shifting back to the underlying economic situation in the United States, which hasn’t really changed very much while everyone’s been focusing on the debt ceiling.
Very sticky inflation, very tight labor markets, US economy is effectively overheating. And the question that markets and policy makers are grappling with is, what will it take to bring inflation down? And that took a backseat for a while, that really important question, while everyone’s focus was on the debt ceiling, but now that’s coming back front and center.
Oscar Pulido: Alex, you said $31.4 trillion, which is a big number even for an economy as big as the US. Can you help clarify some terminology though? We talked about the debt ceiling, you mentioned default, and then we also were hearing about a government shutdown. How do those three things interrelate to each other?
Alex Brazier: So, the debt ceiling, as I say, is set by Congress and it limits the amount of debt that the US government can have issued at any one time. So, as I say, that’s 31.4 trillion, even as you say, relative to the size of the economy, that’s 120% of US GDP. So, it’s a big number. Now default is a situation where the borrower, in this case, the US government, can’t service the debt that it has in issue, so it can’t make scheduled interest payments, it can’t make scheduled repayments of that debt. And the risk here was that because it was going to hit the ceiling and not be able to issue more debt, the US government would’ve had a cash flow problem and been unable to make some of those payments, and therefore it would’ve been in default on its existing debt.
Now, a shutdown is also what happens if the government doesn’t have the cash to run its operations and to pay its employees. And we’ve seen that in previous debt ceiling episodes. And all these things are linked because if the government hits the debt ceiling and has a cash shortage, it effectively needs to shut down its functions. It needs to stop paying its employees, furlough its employees, and it risks not being able to make payments on its debt and therefore it would be in default. So, the debt ceiling, the risk of default and the risk of a shutdown of its operations are all inextricably linked.
Oscar Pulido: It makes sense. And curious then, how has this impacted markets now that the risk of a default seems to have passed? I think that risk is now firmly off the table, if I’m not mistaken.
Alex Brazier: That’s right. I think that the immediate risk is off the table. The debt ceiling itself has been suspended for two years now until 2025. But I think what’s really critical is that this doesn’t mean we can just move on and forget this ever happened. We can’t forget US fiscal policy, the tax and spend policy.
And this episode, this negotiation will actually have a bit of a hangover on US economy and markets in two respects, really. Both of which will add to volatility in bond markets, in fixed income markets.
The first is that the position of US fiscal policy, by which I mean the government’s tax and spending plans, is still pretty challenging. The agreement doesn’t change those plans very much. The congressional budget office yesterday estimated that spending’s going to be about 65 billion lower next year as a result of this agreement. But that’s just 0.3% of the US economy. And you set that against a deficit, which is how much higher spending is than tax revenues, of around seven and a half percent of GDP at the moment, and you can see that actually the impact of this on the overall tax and spend position is actually pretty small.
Now that deficit, that seven and a half percent of GDP deficit, is higher than any time outside the second World War post the global financial crisis and the Covid crisis. And it’s happening at a time when the US economy is actually overheating. So, the US fiscal position is actually in a pretty challenging place and stabilizing government debt in the United States, in a situation where we’ve got higher interest rates, a big deficit actually means that tax and spending plans need to adjust quite a lot over time.
And in our view, market attention will increasingly focus on that over time, rather than on the kind of immediate debt ceiling risks. And that will add to volatility in bond markets.
The second hangover, I think, is that we’re going to see now a burst of issuance by the US government in coming months to effectively replenish its bank account. So, we’re going to see issuance, particularly of short-dated treasury bills, all of this at a time when the Federal Reserve isn’t buying US government debt through quantitative easing, but actually running down its holdings of government debt through so-called quantitative tightening. So that second hangover too is going to contribute probably to some volatility in fixed income markets. So, the immediate risk is off the table, but some of these important hangover effects are going to increasingly come into focus particularly in bond markets.
Oscar Pulido: And Alex, what about equity markets. You mentioned that there’s going to be volatility in bond markets and sometimes that then unnerves the stock market investor, but perhaps the stock market investor is now saying, we have this headline behind us and time to take risk, or how do you think about that situation?
Alex Brazier: I think the equity market, a bit like the rest of us, will be breathing a sigh of relief that this agreement has been reached, but also focusing back on the underlying economic picture, which as I say is one of really sticky core inflation, evidence of a tight labor market and rising wages and an overheating economy really, that presents real challenges for the Federal Reserve. And that’s where the equity market we think will turn its attention back to, and it’s where it was before the debt ceiling episode, but that too was going to contribute to volatility, I think.
Oscar Pulido: And Alex, as we approach the mid-year point, what are you focusing on for the second half of the year?
Alex Brazier: Well, now that we’ve moved on from the debt ceiling issue, we are focused on this underlying economic situation of sticky inflation, tight labor market. And there are really two important macroeconomic questions in the United States now.
The first is how material an economic slowdown is needed to deal with that inflation? The Fed itself thinks a recession might be needed to do that. And the second is, how high will interest rates need to go to do what the Fed wants to do? Recent developments in the labor market and inflation actually suggests there’s a real possibility now of more rate hikes over coming months.
And we’re also focused on some of the longer-term trends, like how AI, demographic shifts, geopolitics and the energy transition will actually affect the economy and markets. It’s difficult to lose sight of those, even amid some of this volatility around the debt ceiling.
So next week, BlackRock is assembling a hundred senior portfolio managers in London to debate many of these issues. I expect it to be pretty lively with some fierce exchanges. I mean, we’re pretty passionate about these issues because this is a new macro environment, it’s really difficult. This inflationary environment’s very different to anything we’ve had for the last 30 years.
And we are totally focused now on how we can unlock the investment opportunities in this new regime for our clients. And that’s what we’ll be debating fiercely next week. And I hope you have us back to discuss some of our conclusions.
Oscar Pulido: We will absolutely have you back, Alex, thank you for providing us this update and we look forward to having you back to hear more about that convening that is taking place in London. Thanks for joining us on The Bid.
Alex Brazier: Thanks, Oscar.
Oscar Pulido: Thanks for listening to The Bid.
This post originally appeared on BlackRock.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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