The make-or-break crises impacting the US

There is a thread running between the three crises being felt in the US right now. The inflation crisis was borne from the pandemic, a politically toxic one. The looming debt ceiling crisis stems from politicking that is more aggravated than ever. And the third crisis is a banking one, in part brought on by a Fed reacting to the inflation crisis. Where now?

We have big issues in play. They have evolved slowly but surely. The coming months will prove to be a make or break period.

• As the baton of power was handed over from Trump to Biden during the pandemic years we had the seeds of inflation sown as an induced boom met with a lack of ability to get hands on stuff. The inflation crisis was borne.

• The pandemic itself did little to calm the extreme heat that had built in politics pre and post Trump; in fact it has only become more intense since. Hence the looming debt ceiling crisis.

• And then, shifting gears from zero rates to 5% ones and from massive liquidity injections to taking them away always risked a reaction somewhere. The crisis in banking is not all down to this, but it’s also clearly not unrelated. The inflation crisis brought this on.

And looking forward, the last thing we really need now is a material threat to the system coming from politics and debt ceiling stubbornness. So what is the market discount as we look forward? 

Inflation crisis resolution as measure by market breakeven inflation rates 

The genesis of bank stresses in part reflects the switch in the stance of Fed policy to tightening on mounting inflation concern. Such concern has eased but has not gone away – latest core PCE readings still identify the US as a “5% inflation” economy. But there is some good news coming from market inflation break-evens, as derived from the difference between conventional Treasury yields and real yields on inflation protected securities. These inflation break-evens not only have 2% handles right along the curve, but moreover are far closer to a big figure 2% than 3%. In fact, the 2yr breakeven has just this week dipped below 2%. If that’s what gets delivered, the Fed’s hiking job is done and dusted, and indeed the ground is laid to rationalise future cuts. While interest rate cuts likely coincide with higher consumer delinquencies and corporate defaults, and there is a feedback loop to the stresses in the banking system, where pressure in the commercial real estate sector remains under immediate scrutiny. This would become further acute should these inflation expectations not be realised, making in more difficult for the Fed to execute those cushioning cuts.

Debt ceiling crisis as measure by US sovereign credit default swaps 

And as we navigate this course, we face into a debt ceiling dilemma laced with political menace that is so intense as to risk a default. Just one missed interest rate payment would imply a default. Market concern on this front is quite elevated, with 5yr Credit Default Swaps now in the 75bp area. This is the highest since the Great Financial Crisis, and is at the widest spread over core eurozone, ever. While there is no cross default in Treasuries, where one defaulted bond pulls the rest into a defaulted state, there would still be a material tarnishing of the Treasury product even if just one interest payment were missed. Many players would not want to take on the risk of having a defaulted bond on their books, and the collateral value of Treasuries would come under scrutiny. One default should not take down the system if holders are immediately made whole through a swift resolution of the debt ceiling. But at this same time things could unravel quite quickly and uncontrollably. In essence the entire global financial system is at threat.

Eforex India Anaylitics, May 8th 2023