The Existential Threat

Scott Anderson
Chief Economist
Bank of the West

Investors will be focused on next week's FOMC decision and the machinations around the FOMC Statement language and Powell's post-meeting press conference trying to discern the likely path of future interest rates. Will the Fed send an explicit signal of one and done, or will they keep their options open for doing more in June and beyond to continue their fight to defeat inflation. The re-acceleration in Core PCE inflation back to a 4.9% annualized pace in the first quarter may prompt some FOMC participants to want to keep their options open for further rate hikes, despite gathering evidence that the bank credit channel tightening has accelerated with the banking turmoil touched off in March. Moreover, will investors need to re-think their expectations of Fed rate cuts in the second half of this year too?

Regular readers of our analysis and reports know our answer to these questions. We think the FOMC will go ahead with a 25 basis point rate hike next week, bringing the Fed funds rate to a range 5.0 to 5.25%, and then enter a prolonged pause as they wait to see if the monetary policy medicine already administered has the desired effect on the economy and inflation. The prospect for rate cuts later this year remains far lower than current market pricing, which still has about 50 basis points in Fed rate cuts before the end of the year.

The April Employment report released next Friday will also garner a lot of attention as investors look for more visible signs of labor market softening to signal a near-term pause in further rate hikes and give stock investors another reason to bid up stocks. We expect U.S. job growth to slow but not peter-out. We are looking for around 175k job gain, down from 236k in March with the unemployment ticking up to 3.6% from 3.5%. We expect service job creation to slow, while the mild contraction in manufacturing jobs already visible over the last two months could accelerate.

But in reality a tweak in monetary policy here and a blip in job growth there will do little to fundamentally alter the near-term economic outlook that already appears headed for further slowing and a labor market headed for additional softening, which eventually culminates in a mild recession before the year is done.

To be perfectly frank, next week's FOMC meeting and the April jobs report are merely a side-show. The true existential threat facing the economic outlook is a failure of Congress to raise or suspend the Federal debt ceiling before the U.S. Treasury runs out of extraordinary measures to pay its bills. Recent estimates now point out this could occur as soon as July given how the April tax revenues appear to be coming in and assuming no agreement is reached before then. But if economic and financial Armageddon is just around the corner, where is the financial market panic?

There is no panic yet because this isn't the first time politicians have played politics with the Federal debt ceiling. In 2011, Congress went very close to the drop dead date causing sizable equity price declines, and a Federal debt downgrade from Standard & Poor's from AAA to AA+ in the process. Most investors continue to tune out the noise in Washington assuming that a looming default risk will once again force a political solution before the worst occurs. We too, appealing to the law of self-preservation, think a Federal debt default is a low probability event today, but it's hard to have any conviction given where the two sides are right now.

Kevin McCarthy's House of Representatives passed a bill this week that has nearly zero chance of becoming law, and remains miles apart from what President Biden and the Democrats in Congress say they can support. McCarthy's bill links substantial discretionary spending cuts ($3.2 trillion over 10 years) for a temporary one-year $1.5 trillion raise of the Fed debt ceiling level. While optimists point out passage of the House bill gives the two sides a starting point for negotiations on spending cuts to begin, some parts of the market at least are starting to have their doubts things are moving in the right direction.

The cost of insuring against a Treasury default over the coming year is now the highest on record - far surpassing levels seen in the 2011 debt ceiling crisis or during the 2008 Great Recession. Even more troubling, the CDS spread appears to have skyrocketed since the passage of McCarthy's bill. The 1-Yr CDS Spread was trading around 198 on Thursday up from 116 just last Thursday prior to the passage of the House bill and its more normal level of around 12 over the past 5 years. The higher the CDS spread the more expensive for investors to insure against a Treasury default. This should be a clear market signal to Congress and the White House that the economic and financial damage from going up to the brink, or over it this time, could be much higher than any other time in the past.

Cost Of Insuring Against a U.S. Default Never Been Higher

Our base case has been that these debt-ceiling negotiations play out a lot like 2011. We have a political game of chicken that goes right down to the wire with both sides trying to score political points, causing a bit of instability in stock and bond markets, perhaps even another debt downgrade from one of the ratings agencies, but we don't go completely over the edge into default.

Even a temporary or technical default for a short period of time could do signification short-term as well as permanent economic and financial damage. It would force a sharp, if temporary, pull-back in Federal spending, a large drop in stock and bond prices, and a freezing up of short-term credit markets just to start, precipitating a more severe and prolonged economic recession than we already have in our baseline forecast. We are talking about a recession with a 6.0% plus unemployment rate at its peak. If the debt default lasts for weeks or even a month or more, we are talking Great Recession levels of job losses and economic damage that would be difficult to ever recover from. As you can imagine, it's the debt ceiling, not the Fed or the banking turmoil, that is keeping me awake at night these days. I will be monitoring events in Washington extremely closely until a deal is struck and you should too, your economic and financial future will depend on it.

To learn more, check out this week's U.S. Outlook Report.


[Contributors Section]