Debt ceiling suspended until Jan 2025: Fiscal health to be general election issue

Republicans ask for very little to suspend the debt ceiling. Their strategy appears to be let federal debt grow into a major issue for the Nov 2024 general election. House Speaker Kevin McCarthy and President Joe Biden announced an agreement in principle to suspend (not lift) the debt ceiling by freezing non-defense discretionary spending through Sep end 2024. Their accord boosts defense spending by 3.5% next fiscal year. Other aspects of the tentative deal are of small budgetary significance and not binding to a future Congress. No limits specified for other 70% of federal spending, e.g. Social Security, Medicare, Medicaid, Veteran Benefits; nor executive spending under emergency and no new boundaries. This spending will rise as entitlements and need require, so blue sky for Treasury bond issuance until Jan 2025.

Inflation is unlikely to land on target this year or next with loose fiscal discipline

Before Memorial Day weekend, April’s Personal Consumption Expenditures and inflation measures surprised to the upside. The U.S. Federal Reserve’s (Fed) most favored measure of inflation, core PCE accelerated to 4.7% y/y and 4.5% m/m annualized. The details of consumption suggest households are depleting savings to spend more on essential goods and services. We think the Fed will take this most recent and important datapoint and likely stare at it. For over two years, the Fed has hoped for reopening normality or productivity upside surprises to tame inflation. The Fed was too late to hike, too early to shrink the size of hikes and will likely err again by being too early to pause. Despite many hikes since March 2022, the Fed Funds rate is only where it was in 2006-2007 before the financial crisis. Oil prices were a problem back then, but inflation was nowhere close to today’s breadth and persistence.

Slowflation: It’s not cyclical inflation, it’s structural: Real growth will be very slow

If the Fed chooses to pause for summer, we don’t know if the economy will slip into recession later this year or not. But given the data, at this stage we are convinced it will take at least a small recession to put inflation under 3% this year and next. Despite tighter credit conditions from smaller banks suffering net interest margin pressures from the jump in deposit base costs, we think a no landing scenario now has a 1/3 chance or roughly the same for soft landing (small recession w/ Unemployment Rate <5%) and hard landing (bigger recession w/ UE 5%+) if the Fed doesn’t hike more this summer. Our no landing scenario has inflation between 3-5% through 2024 with no definitive recession, but real growth stuck around 1%.

Stubborn inflation, deteriorating US fiscal health: 10yr Treasury yield likely rising

May was the month that short-term Treasury investors got the message that without a large recession the Fed was unlikely to cut overnight rates until probably spring of 2024. We think June & July, if the Fed doesn’t hike, will be months that longer-term Treasury investors realize that without a recession this year inflation is unlikely to fall below 2.5% over the next few years and real interest rates are likely to stay over 1% for the rest of the decade. Without conviction in imminent recession, we’d be uncomfortable owning 10yr Treasuries yielding under 4%. While the Fed has signaled that the terminal rate and angle of ascent are uncertain, we think they’ve been clear in desire to stay at that rate for at least a year, like past plateaus, and that positive real interest rates are likely appropriate for much longer than that, just as before the surge in globalization and the financial crisis. We think longer-term real interest rates (Treasury Inflation-Protected Securities, or TIPS) should be about 1.5% and that Treasury breakeven should be about 2.5% with inflation risk premiums being approximately offset by risk hedge value. But, Treasury risk hedge value is uncertain until yields normalize, wherever that might be.

Higher short and long-term nominal & real interest rates underlie debt problem

The deficit remains too high for a full employment economy and the debt to gross domestic product (GDP) ratio is at levels that would give fiscal hawks from the 1980s a heart attack. But rising debt to GDP wasn’t a problem when interest rates were descending and then spent years at 0% and negative real rates. This is not the case with interest rates today and with the debt ceiling suspended, we expect Treasury to issue more than $1trn of notes before year end and the deficit to exceed 5% of GDP this year and next. Unless inflation is 4% or more, we expect the debt to GDP to climb. More importantly, we expect interest expense on debt and as a share of GDP to rise. This was under 3% until this year and we expect it to be over 4% by next year. Treasury will need to decide on whether it wants to issue mostly short-term debt at 5% or longer-term debt still under 4%. Unless a recession that quickly tames inflation is expected, we’d suggest issuing more toward the long end. But we hear they’ll likely issue mostly short, which is more costly and might stay more costly than long-term rates are now. It could be a muggy summer for long-term bonds, if it gets too hot it will also burn stocks.