You hang around financial markets for long enough and you start to notice some patterns. Crises, for instance, rarely tend to have single causes. They are rather exactly what Charlie Munger has pointed out--lollapaloozas where multiple causes cascade into larger financial panics.
You can probably see where I'm going with this. It's already a pretty precarious time for the U.S. economy and financial markets. The yield curves are super inverted. Things are worryingly out of whack. Growth is rapidly slowing. Recession is more or less imminent. We just erased $12 trillion of wealth in about twelve months' time. This is a lot of dry tinder.
If you wanted to spark, say, a financial crisis, then throwing a potential U.S. debt default into the mix would be just the ticket. "The debt ceiling battle is already impacting the Treasury Bill market, and may be more impactful to the equity market than the 2011 battle that cost the U.S. its 'AAA' rating and briefly caused stock prices to plummet," warned strategist Brian Reynolds in a recent client note.
Back in July and August of 2011, stocks plunged 18% in less than three weeks, he reminds us. It could easily take a similar drop this time around to "get legislators' attention to come to an agreement." And the impact on the bond market could be even larger. Yields on Treasury bills that mature in July are already trading higher than they otherwise should be, reflecting the extra risk premium.
That's making the yield curve inversion extra worse right now, which is likely to keep a near-term lid on stock prices, Reynolds cautions. It's also painful for money market funds--one of the biggest holders of short-term U.S. Treasurys--to now have to scramble to move that cash around to avoid redemptions like we saw in 2011. "We have no words to describe how bizarre it is for the government to force money market funds into government securities [after the financial crisis] and then threaten to default on those securities," he adds.
Point being, this unpleasant interplay is the last thing we need to deal with right now. It even complicates the Fed's "quantitative tightening" plans--which you could argue is actually a good thing, given that it appears they've already over-tightened with rate hikes. Already, "QT" has prompted a surprisingly quick drawdown in bank reserves, the same thing that precipitated the 2019 repo crisis during the last attempt to shrink the Fed's balance sheet.
Based on the slowing economy alone we could even be back to rate cuts and quantitative easing by the end of this year. If you mess with short-term funding markets--as a debt ceiling fight is already starting to do--you make that reality more likely. Any politicians who are fed up with the path the Fed and fiscal government have been on in terms of spending and debt will not be happy to see us back to "QE" by year-end, which a debt ceiling fight could lead us into.
I'm not the only one worried about the fragility of markets and the economy here. David Zervos sees similar precariousness in the Fed funds futures market. Traders know the Fed will be so reluctant to ease that it will take a pretty big crisis to force them back in. What markets are pricing in right now is not "a rate cut or two" by year-end, but rather a small chance that we need huge rate cuts if we suddenly start to lose 700,000 to 800,000 jobs a month, for instance.
"For now, they are ONLY around to help in the very unlikely event of a crash landing," Zervos wrote to clients this morning. My point being: a debt ceiling fight could be just the type of thing that crashes the plane.
See you at 1 p.m!
Kelly
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