The Ceiling for Debt

To traders, the ceiling for debt
Is starting to grow as a threat
As Yellen explained
She’ll soon be constrained
From paying our bills, just not yet

Some folks claim an alternate way
Exists which could help save the day
To quickly influx
A cool trillion bucks
Just mint a new coin to help pay

In addition to all the Congressional drama over the Biden spending agenda, the US is also being buffeted by the debt ceiling drama.  We’ve all seen this movie before, where US law requires Congress to approve the amount of debt that can be issued by the Treasury in order to pay for the spending that Congress mandates.  (A little-known fact is that the debt ceiling was not enacted to impose discipline on Congress, in fact it was the opposite.  Prior to the debt ceiling’s implementation, Congress was required to vote on the funding for each spending bill they enacted on an individual basis.  The debt ceiling was created to allow Treasury to fund the Congressional spending mandates in a smoother and more efficient manner.  My how things have changed!)  But back to our story… the current situation is that the debt ceiling has been reached and the Treasury is not empowered to issue any new debt (it can roll over maturing debt) in the current situation.  While the Treasury does have some cash on hand, and can move funds around in its various accounts, by most measures, it appears that there are about 2 weeks of funding left before the government will have to default on paying some bills on a timely basis.

Now default was never contemplated by the Founding Fathers, with them going so far as to explain in Section 4 of the 14th Amendment of the Constitution:

The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned. But neither the United States nor any State shall assume or pay any debt or obligation incurred in aid of insurrection or rebellion against the United States, or any claim for the loss or emancipation of any slave; but all such debts, obligations and claims shall be held illegal and void. [author’s emphasis]

It is this confluence of events which has led to a somewhat creative thought regarding how the government can overcome their problem, minting a trillion-dollar platinum coin.  One thing that is clear is that the Treasury has the legal right to mint coinage, which is why despite the talk of the Fed printing money, the actual money printer is the Treasury department.  Those $20 bills in your wallet are printed at the US Mint, a part of the Treasury.  And the right to print money is fiercely protected by every nation as it is a good source of revenue (known as seignorage).  Consider, they print money and can use it to buy real stuff, whether tanks, or medicines or anything else.  All of those things cost far more than the paper that money is printed on.  As well, paper money is considered part of the Treasury’s coinage capability.

Now, in economic terms, $20 bills are actually zero-coupon perpetual bonds.  A claim on a fixed notional of assets with no interest rate paid and no maturity date.  The same is true with quarters and dimes and nickels, no maturity date, no interest rate, some ascribed value.  This has led to the idea that the Treasury can mint a coin with a notional value of $1 trillion (made of platinum to denote its high value), deliver it to the Fed and get $1 trillion of spending power in their general account.  This idea was first mooted in 2011 as a similar split in Congress brought the US government very close to an actual default.  Ten years later, as the concept of MMT has become more widely accepted as a viable path forward (it’s NOT), the idea is once again gaining traction.  It certainly solves some problems, notably it prevents a default, but more importantly to the Democrats in Congress, it prevents a distasteful political vote that can be used as a cudgel by Republican opponents in the next election.

Of course, my question is, why would they stop at $1 trillion?  After all, if current spending plans are for $5 trillion, why not mint five coins, or ten so they have some spare change?  You can see the danger of this slippery slope, especially in the current economic environment where inflation is already running rampant.  The addition of $1 trillion or $5 trillion more into the economy without the creation of new products or services would really turbocharge inflation.

While thus far, it seems this idea remains at the margin, given the dysfunctionality of Congress these days, and the shrinking timeline for action, it cannot be ruled out.  My sense is that while it could have a short-term positive impact on the dollar and markets, it would relatively quickly be understood to be a massively inflationary action with both bonds and the dollar suffering accordingly.

OK, with that food for thought, let us take a look at market activity today.  The first thing to note is that China is in the midst of its Golden Week holidays, which means there are no markets there until next week.  Hong Kong (-2.2%) and Tokyo (-1.1%), however, were both open, although neither had a very positive session.  Hong Kong suffered as they halted trading in Evergrande shares and other real estate companies fell sharply.  Europe, on the other hand has edged slightly higher this morning, (DAX +0.0%, CAC +0.2%, FTSE 100 +0.2%) although it is hard to get too excited over the movement.  US futures, on the other hand, are all pointing a bit lower, on the order of -0.4% at this hour.

Bond markets are seeing some selling this morning with 10-year Treasury yields higher by 3.5bps, although since the very sharp move last week, they have been consolidating either side of 1.50% yields.  European sovereigns are also under some pressure with yields there moving up (Bunds +1.8bps, OATs +1.6bps, Gilts +2.0bps), although there has been precious little news on which to trade.

In the commodity market, oil prices continue to trade higher (WTI +0.3%) as does Nat Gas (+2.3%).  While precious metals are under some pressure (Au -0.6%), industrial metals are firm this morning (Cu +1.35%, Al +0.6%) and agricultural prices are mixed in slow trading.

As to the FX market, the dollar is definitely under some pressure this morning with CHF (+0.45%) leading the way higher in the G10 with NOK (+0.4%) and GBP (+0.4%) next in line.  The only laggard today is JPY (-0.15%) which is confusing given the Swiss franc’s performance as otherwise, one could consider this a somewhat risk-on day.  But US equity futures are not helping that story either.  In the EMG space, things are a little clearer as the CE4 (HUF +0.75%, PLN +0.6%, CZK +0.3%) are the top performers as all of them continue to get supported by central bank comments regarding tighter monetary policy.  On the downside, MXN (-0.45%) is suffering the opposite as Banxico comments indicated that there would be no 50 basis point rate hikes anytime soon, something the market was beginning to price in.  Net, the dollar is probably slightly softer, but the recent uptrend remains intact.

Data this week is fairly slow up until Friday’s payroll report:

Today Factory Orders 1.0%
Tuesday Trade Balance -$70.6B
ISM Services 59.9
Wednesday ADP Employment 430K
Thursday Initial Claims 350K
Continuing Claims 2770K
Consumer Credit $17.5B
Friday Nonfarm Payrolls 470K
Private Payrolls 450K
Manufacturing Payrolls 25K
Unemployment Rate 5.1%
Average Hourly Earnings 0.4% (4.6% Y/Y)
Average Weekly Hours 34.7
Participation Rate 61.7%

Source: Bloomberg

A couple of things worth mentioning are that last week, the NFP forecast was 535K, so starting to slip.  Also, we continue to hear that there is no wage inflation, yet 4.6% Y/Y will be the highest non-Covid related level since before the GFC.  On the Fed speaker circuit, this week is far less noisy with only 4 speakers, none of whom are going to change the narrative.

As to the dollar overall, I believe we are in an uptrend for now, having broken through previous strong resistance, and I expect that we are likely to see this trend continue.  Use pullbacks to hedge, but they will not be large in my view.

Good luck and stay safe
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Far From Surreal

The Fed explained that they all feel
A taper is far from surreal
The goal for inflation
Has reached satiation
While job growth ought soon seal the deal

Heading into the FOMC meeting, the consensus was growing around the idea that the Fed would begin tapering later this year, and the consensus feels gratified this morning.  Chairman Powell explained that, if things go as anticipated, tapering “could come as soon as the next meeting.”  That meeting is slated for November 2nd and 3rd, and so the market has now built this into their models and pricing.  In fact, they were pretty clear that the inflation part of the mandate has already been fulfilled, and they were just waiting on the jobs numbers.

An interesting aspect of the jobs situation, though, is how they have subtly adjusted their goals.  Back in December, when they first laid out their test of “substantial further progress”, the employment situation showed that some 10 million jobs had been lost due to Covid-19.  Since then, the economy has created 4.7 million jobs, less than half the losses.  Certainly, back then, the idea that recovering half the lost jobs would have been considered “substantial further progress” seems unlikely.  Expectations were rampant that once vaccinations were widely implemented at least 80% of those jobs would return.  Yet here we are with the Fed explaining that recovering only half of the lost jobs is now defined as substantial.  I don’t know about you, but that seems a pretty weak definition of substantial.

Now, given Powell’s hyper focus on maximum employment, one might ask why a 50% recovery of lost jobs is sufficient to move the needle on policy.  Of course, the only answer is that despite the Fed’s insistence that recent inflation readings are transitory and caused by supply chain bottlenecks and reopening of the economy, the reality is they have begun to realize that prices are rising a lot faster than they thought likely.  In addition, they must recognize that both housing price and rent inflation haven’t even been a significant part of the CPI/PCE readings to date and will only drive things higher.  in other words, they are clearly beginning to figure out that they are falling much further behind the curve than they had anticipated.

Turning to the other key release from the FOMC, the dot plot, it now appears that an internal consensus is growing that the first rate hike will occur in Q4 2022 with three more hikes in 2023 and an additional three or four in 2024.  The thing about this rate trajectory is that it still only takes Fed Funds to 2.00% after three more years.  That is not nearly enough to impact the inflationary impulse, which even they acknowledge will still be above their 2.0% target in 2024.  In essence, the dot plot is explaining that real interest rates in the US are going to be negative for a very long time.  Just how negative, though, remains the $64 trillion question.  Given inflation’s trajectory and the current school of thought regarding monetary policy (that lower rates leads to higher growth), I fear that the gap between Fed Funds and inflation is likely to be much larger than the 0.2% they anticipate in 2024.  While this will continue to support asset prices, and especially commodity prices, the impact on the dollar will depend on how other central banks respond to growing inflation in their respective economies.

Said China to its Evergrande
Defaulting on bonds is now banned
So, sell your assets
And pay dollar debts
Take seriously this command

CHINA TELLS EVERGRANDE TO AVOID NEAR-TERM DEFAULT ON BONDS

This headline flashed across the screens a short time ago and I could not resist a few words on the subject.  It speaks to the arrogance of the Xi administration that they believe commanding Evergrande not to default is sufficient to prevent Evergrande from defaulting.  One cannot help but recall the story of King Canute as he commanded the incoming tide to halt, except Canute was using that effort as an example of the limits of power, while Xi is clearly expecting Evergrande to obey him.  With Evergrande debt trading around 25₵ on the dollar, and the PBOC continuing in their efforts to wring leverage out of the system, it is a virtual guaranty that Evergrande is going under.  I wouldn’t want to be Hui Yan Ka, its Chairman, when he fails to follow a direct order.  Recall what happened to the Chairman of China Huarong when that company failed.

Ok, how are markets behaving in the wake of the FOMC meeting?  Pretty darn well!  Powell successfully explained that at some point they would begin slowing their infusion of liquidity without crashing markets.  No tantrum this time.  So, US equities rallied after the FOMC meeting with all three indices closing higher by about 1%.  Overnight in Asia we saw the Hang Seng (+1.2%) and Shanghai (+0.4%) both rally (Japan was closed for Autumnal Equinox Day), and we have seen strength throughout Europe this morning as well.  Gains on the continent (DAX and CAC +0.8%) are more impressive than in the UK (FTSE 100 +0.2%), although every market is higher on the day.  US futures are all currently about 0.5% higher, although that is a bit off the earlier session highs.  Overall, risk remains in vogue and we still have not had a 5% decline in the S&P in more than 200 trading days.

With risk in the fore, it is no surprise that bond yields are higher, but the reality is that they continue to trade in a pretty tight range.  Hence, Treasury yields are higher by 2.4bps this morning, but just back to 1.324%.  Essentially, we have been in a 1.20%-1.40%% trading range since July 4th and show no sign of that changing.  In Europe, yields have also edged higher, with Bunds (+1.6bps) showing the biggest move while both OATs (+0.9bps) and Gilts (+0.6bps) have moved less aggressively.

Commodity prices are mixed this morning with oil lower (-0.7%) along with copper (-0.25%) although the rest of the base metal complex (Al +0.6%, Sn +0.55%) are firmer along with gold (+0.3%).  Not surprisingly given the lack of consistency, agricultural prices are also mixed this morning.

The dollar, however, is clearly under pressure this morning with only JPY failing to gain, while the commodity bloc performs well (CAD +0.8%, NOK +0.6%, SEK +0.5%).  EMG currencies are also largely firmer led by ZAR (+0.9%) on the back of gold’s strength and PLN (+0.6%) which was simply reversing some of its recent weakness vs. the euro.  On the downside, the only notable decliner is TRY (-1.4%), which tumbled after the central bank cut its base rate by 100 basis points to 18% in a surprise move.  In fact, TRY has now reached a record low vs. the dollar and shows no signs of rebounding as long as President Erdogan continues to pressure the central bank to keep rates low amid spiraling inflation.  (This could be a harbinger of the US going forward if we aren’t careful!)

It is Flash PMI day and the European and UK data showed weaker than expected output readings though higher than expected price readings.  We shall see what happens in the US at 9:45. Prior to that we see Initial Claims (exp 320K) and Continuing Claims (2.6M) and we also see Leading Indicators at 10:00 (0.7%).  The BOE left policy on hold, as expected, but did raise their forecast for peak inflation this year above 4%.  However, they are also in the transitory camp, so clearly not overly concerned on the matter.

There are no Fed speakers today although we hear from six of them tomorrow as they continue to try to finetune their message.  The dollar pushed up to its recent highs in the immediate aftermath of the FOMC meeting, but as risk was embraced, it fell back off.  If the market is convinced that the Fed really will taper, and if they actually do, I expect it to support the dollar, at least in the near term.  However, my sense is that slowing economic data will halt any initial progress they make which could well see the dollar decline as long positions are unwound.  For today, though, a modest drift higher from current levels seems reasonable.

Good luck and stay safe
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