The United States Senate in the first week of June this year provided a respite for the domestic (and of course, the global markets) economy, by narrowly passing a bill to suspend the debt ceiling, sending the legislation to President Joe Biden’s desk and averting a disastrous federal default, all in just a few hours.
“Tonight’s vote is a good outcome because Democrats did a very good job taking the worst parts of the Republican plan off the table. And that’s why Dems voted overwhelmingly for this bill, while Republicans certainly in the Senate did not,” the Senate majority leader, Democrat Chuck Schumer, said after the voting process.
Understanding the debt row
Joe Biden and Republican House Speaker Kevin McCarthy sealed the fresh debt ceiling agreement after weeks of high-stakes budget negotiations to prevent global financial chaos from unfolding.
The debt limit, which is also a law, limits the total amount of money the federal government can borrow to pay its bills, along with salaries for federal employees, the military, social security and medicare, as well as interest on the national debt and tax refunds.
The US Congress is primarily entrusted to go for votes to raise or suspend the ceiling so it can borrow more. The cap in 2023 currently stands at roughly $31.4 trillion. This limit was breached in January this year, but the Treasury used ‘extraordinary measures’ to provide the Biden government with more cash.
The matter got complicated further at the Congress level, due to the growing ideological polarisation, the parties were finding it difficult to come to common terms and raise the debt ceiling.
Treasury Secretary Janet Yellen earlier warned that without more borrowing, the Biden government will not have enough money to meet all of its financial obligations as soon as 5 June. However, with the Senate’s last-minute mad rush, the crisis has been averted.
In May 2023, Republicans put forward a deal to keep spending for key agencies at 2022 levels during the 2023/24 financial year and limit growth to 1% annually over the next decade. The proposal would have also repealed key priorities of the Biden government (priorities like student loan forgiveness and tax incentives for electric vehicles). The Republicans’ deal also wanted more work requirements for those receiving healthcare and food welfare.
However, the latest deal ensures a freeze on non-defence budgets for 2024, followed by a 1% rise the following year and no budget caps after 2025. The compromise would avert a situation where the federal and military employees would have been serving without salaries, social security cheques getting stopped, businesses and charities depending on government funds looking at peril, and the whole country going into default.
Yes, a similar situation occurred in 1979. Then, the Treasury put the blame on an accidental cheque processing issue, but it almost put pressure on the global financial system, where over USD 500 billion in US debt gets traded every day (as per 2023 data).
Moody’s Analytics now predicts that if another debt standoff happens in the United States, the result will be stock prices falling by almost a fifth and the economy contracting over 4%, along with the loss of over seven million jobs. Just because the debt crisis is over, that doesn’t mean that the world’s largest economy is out of the woods yet.
Double demon of recession and inflation
The US economy is now showing signs of cooling as hiring and inflation have eased slightly, mentioned the Federal Reserve in its Beige Book survey of regional business contacts.
The survey stated that the economic activity was little changed in April and early May of 2023. This data will now go to the Fed officials and monetary experts, who will assess the effects of their 14-month-long monetary policy tightening campaign. During the timeframe, interest rates were raised to a range of 5% to 5.25% from near zero. The Beige Book also shows that the US economy is still growing, and inflation is mostly on a downward trajectory.
Now some officials are reportedly batting for rate hikes to be paused, while another section, wary of the persistent inflation, feels that the Fed needs to do more. Job openings have surged in April 2023 to a three-month high, suggesting that the American labour market remains hot. The unemployment rate is at 3.4%, a half-century low.
Talking about inflation, the Fed’s preferred gauge picked up in April by more than forecast, it has come down below 5%, compared to the 8.26% in 2022, but still well above the Fed’s 2% target. The gains here are the rise in the sales of new homes, the highest level since March 2022.
Wall Street is not happy
The CEO confidence measure published by the Conference Board reveals that the world’s top business leaders are overwhelmingly anticipating a recession in the United States over the next 12 to 18 months. It will be a one-short one, with a limited global spillover. An outsized 87% of the survey participants envision the recession, while 6% anticipate the phenomenon to be a deep one.
As per reports, companies are in the midst of an earnings recession, suggesting that their profits have contracted for two straight quarters, starting with a 4.6% drop from the 2022 end.
Profits for S&P500 companies shrank just over 2% in the first quarter of 2023. This figure is better than the previous forecasts of a 6.7% drop, but that doesn’t mean that the pain is not there, as analysts polled by FactSet are now expecting a 6.4% contraction for profits in the coming months.
Many companies raised prices following the pandemic and although consumers were more than willing to pay, thus resulting in record profit margins for the businesses, these high price tags have made consumers concerned in the long run, thus impacting consumption.
In the 2023 first quarter, companies specialising in areas like raw materials, utilities and healthcare saw big profit contractions, along with their communications and technology peers, thus suggesting the potential demand slowdown among the consumers due to inflation and the resultant high prices.
Businesses are also dealing with high costs and a tight labour market. Profit margins and overall earnings are expected to fall throughout 2023, according to a report by Wells Fargo Investment Institute.
While FactSet research shows that the number of companies citing recession declined for a third straight quarter, the tally is still above the five-year average. And Wall Street’s concern and discontent are not unjustified either.
You have the minutes of the Federal Open Market Committee’s March 2023 meeting, where policymakers of the US central bank considered pausing interest rates after the failure of two regional banks (the mishap was quickly followed by two more) and a forecast of the banking sector stress potentially tipping the country’s economy into recession.
An ailing banking sector
In May 2023, the Biden administration seized troubled First Republic Bank and promptly sold all of its deposits and most of its assets to the country’s biggest bank, JPMorgan Chase, in order to arrest the sector going downhill, which started earlier in the year with the downfall of the Signature Bank and Silicon Valley Bank.
Treasury Secretary Janet Yellen is doing her best to calm down the anxious stakeholders, by saying that the country’s banking sector is on the ‘stabilization’ path, but the situation still remains dicey.
The recent series of bank collapses have resulted in a crisis of confidence. Customers are withdrawing money from medium and small-sized banks and placing this capital in larger financial institutions.
“Aggregate deposit outflows from regional banks have stabilized following authorities’ moves to shore up confidence and stem contagion,” Yellen stated recently, while also talking about Fed’s new lending tool for banks, in order to improve the latter’s access to liquidity.
The failed banks used the short-terming funding option to grow quickly, while their assets got heavily invested in Treasury bonds and mortgage-backed securities, entities which carry performance risks, in case the Fed tightens its monetary policy. Also, these banks reportedly contained a large portion of uninsured deposits and short-term liabilities that generally get withdrawn in a blink of an eye.
These three banks had asset and liability duration mismatches, which made them vulnerable to uninsured depositor runs. When these depositors started withdrawing their money en masse, that spelt doom for these banks.
Just take the First Republic as a case study. While SVB had 57% of its assets in bonds and the unrealised losses on these portfolios spooked its depositors, at First Republic, only 15.5% of its assets were in bonds and they were mostly held to maturity, with the bank having no urgency to recognise the losses from rising Fed rates unless it was forced to sell these bonds.
However, First Republic assets caused the ‘Big Bond Holdings’ problem for the institution. For example, it had interest-only home loans that weren’t due to get any principal repayments for 10 years, something similar to a 10-year bond, booked at face value in the accounts.
These interest-only home loans were made at cheap rates to customers like the other bank CEOs, as part of First Republic’s strategy of growing its wealth-management business. The bank used this lending to win deposits and help grow both sides of its balance sheet. Experts dubbed the whole business model looked like a fallible one.
And that happened, as the institution lost over $100 billion of customer deposits in the 2023 first quarter, 41% of which came at the 2022 end. The bank was ultimately left with $55 billion of insured deposits, $20 billion of uninsured deposits and $30 billion of those term deposits from other big banks.
First Republic’s mortgage book had a carrying value of $136.8 billion in 2022 and it estimated its immediate resale value at $117.5 billion, resulting in a $19 billion loss. This loss amount was well over First Republic’s core regulatory capital of $13.9 billion.
On May 4 2023, shares of two other regional banks, PacWest Bancorp and Western Alliance, went down by 51% and 39%, respectively.
Given the fact that most of the regional American banks deal in holdings, the equity bases of these financial institutions are insufficient to sustain big losses on these holdings. This year has so far been about reduced deposits and increased funding costs hurting American banks’ profitability and business models.
This ongoing stress has the potential to translate into a credit crunch, with regional lenders tightening their lending standards after the recent series of bank failures. This will reduce credit availability for small businesses, low-income households, and most importantly, the commercial real estate sector.
While one can easily blame the failed banks’ management for their erroneous business calls, Fed’s role can’t be overlooked either, which in the pursuit of controlling the sky-high inflation, went on a rate hike spree since the early months of 2022.
Why Fed?
Regional and small banks have been the prime sufferers of these monetary policy moves. Not only have they endured losses on long-dated securities, but these banks also encountered massive outflow of deposits to larger banks and money market funds. All these things have resulted in lower profits and higher funding costs for these banks.
While the Fed pursued an ultra-loose monetary policy stance (even during the COVID period) till 2022, regional banks got large deposit inflows, despite having poor loan demands from households and businesses. The banks invested in these capitals into lower-risk, long-term US Treasury bonds and mortgage securities.
These investments were always subject to interest rate risks, along with the recorded duration mismatch between banks’ assets and liabilities with long-dated securities and short-dated demandable deposits.
The value of these bonds went downhill as the Fed started raising the interest rates in March 2022, given the fact that these interest rates and bond prices are related to each other and bond prices go down when interest rates rise.
Rising interest rates resulted in losses for these regional banks. With depositors withdrawing funds and investing in these capitals somewhere else to generate higher returns, the regional banking sector had no option apart from selling their long-term bonds prematurely at a loss. SVB, First Republic and Signature, all three banks became the victim of this process.
The sector is currently witnessing a contrasting picture. On one hand, in March 2023 alone, the mutual fund sector suffered a 6% loss, reflecting a dented investors’ sentiment, and then you have the update of banking shares making strong rebounds in the market.
Biggies like Wells Fargo, Goldman Sachs, Morgan Stanley, Citigroup and Bank of America are presently performing strongly in the stock markets, but it doesn’t mean that all is okay now. The series of banking collapses have exposed a vulnerable area of American banking, which is the regional lending institutions’ trading on government bonds and securities and then suffering whenever Fed raises interest rates.
The debt ceiling crisis has been averted for now. As per the current GDP trends compiled by CapitalSpectator.com, the odds of the world’s largest economy going into a recession remains. The numbers also suggest that the country will continue to expand in the coming days. Also in May 2023, the nation added 339,000 jobs, thus defying any slowdown talks.
However, as inflation continues to dominate the economies around the world, the United States has another demon to deal with, in the form of its crisis-ridden domestic banking sector. And addressing the worries around this particular sector, in all likelihood, will be the biggest test for the Joe Biden government in the coming days.