Worries over the debt ceiling have had the stock market on edge, yet the Saturday night deal to avoid a default may not trigger a big relief rally. That's because aggressive Fed tightening and the end of the last Covid-era fiscal giveaways appear likely to help push the U.S. economy into recession later this year.
The rocket fuel of easy money and excessive government spending that propelled GDP, inflation and, for a long while, the stock market is nearly spent. A fiscal hangover is just beginning.
While the debt-ceiling deal reached by President Biden and House Speaker Kevin McCarthy includes pretty mild spending curbs, one detail could pack a punch. News reports indicate that the deal will codify into law the Biden administration's planned end of the student loan payment freeze that has helped fuel spending over the past three years.
That will likely deepen a spending slowdown at a time that growth already has slowed almost to a stall. Yet the Federal Reserve, after five percentage points of rate hikes, may step even harder on the brakes. After last Friday's hotter-than-expected PCE inflation report, Wall Street now thinks another rate hike is likely in June or July.
Meanwhile, any debt-ceiling relief for investors will be fleeting because the stock market is about to lose its own fiscal support.
The Treasury's inability to issue debt in recent months has more than offset Fed efforts to tighten financial conditions by unloading assets purchased during the Covid-19 pandemic. But Treasury issuance is likely to surge following a deal to raise the debt ceiling. That means we're about to get Fed quantitative tightening on steroids.
The latest Fed data shows the Treasury's account at the Fed had fallen to $49.5 billion as of last Wednesday. The account balance is normally around $500 billion, Swissquote Bank market analyst Ipek Ozkardeskaya noted after the debt-ceiling deal. "This means that the U.S. Treasury will be sucking around half a trillion dollars from the market very shortly."
"We don't know at what speed at which the market liquidity will drain, but we know that it will drain."
Debt-Ceiling Deal
Facing a possible June 5 debt-ceiling breach, Biden and McCarthy reached a deal with much more modest spending curbs than House Republicans proposed. Instead of cutting discretionary spending back to 2022 levels, the cuts would hold nondefense spending at roughly 2023 levels, while exempting military and veterans' health spending. For fiscal 2025, the discretionary budget allowance increase would be limited to 1%, below the rate of inflation.
The deal tightens work requirements for adults without children to receive food aid, while exempting the homeless and veterans. It also trims $20 billion from the extra $80 billion in IRS funding that Democrats passed to boost tax enforcement.
The White House has been resigned to at least modest discretionary spending cuts as part of a debt-ceiling deal. Even if President Biden had attempted an end run — such as by declaring that the debt limit is itself unconstitutional — he would have still needed the GOP-controlled House to sign off on the 2024 budget before the new fiscal year begins Oct. 1.
Failing that, the government might have shut down until the parties reached a spending deal. The last partial shutdown under former President Donald Trump eventually grounded air traffic while delaying paychecks for 800,000 federal workers, as well as contractors. A repeat scenario would surely amplify U.S. recession risks.
McCarthy may have had limited leverage, since any deal would need Democratic votes to pass. If he pushed too hard, Biden also may have resorted to a controversial plan to get around the debt ceiling.
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Student-Loan Payments
While the debt-ceiling deal averts the potential for harsh economic fallout that might have come from a breach, another fiscal time bomb is lurking.
Biden's $400 billion student-loan forgiveness program faces a Supreme Court ruling in late June. If the justices find that GOP-run states have standing to sue, there's a strong chance Biden won't like the verdict. Recent rulings by the conservative-dominated court show little patience for government agencies adopting consequential policies without the explicit consent of Congress.
A ruling against Biden's program to forgive up to $20,000 in federal college loans per person could hit borrowers by September. Biden has set an end-of-August deadline for lifting a three-and-a-half-year moratorium on student-loan payments.
The halt of student loan payments for about 40 million borrowers has cost the government more than $5 billion per month, including forgone interest, according to the Committee for a Responsible Federal Budget.
Yet that understates the extent to which the payment pause for $1.3 trillion in student loans with a median balance of $18,773 has helped consumer finances.
The average student loan payment was $393 per month for borrowers before the pandemic, Jefferies economist Thomas Simons notes.
"Consumer balance sheets are already kind of exhausted at this point," Simons told IBD.
With the added pressure from an end to the student-loan holiday, "We're setting up for a pretty significant rollover" for consumer spending in the second half of the year, he said.
Other Fiscal Drags To U.S. Economy
After dodging recession fears in 2022, the U.S. economy appeared to rev back up to start 2023. The Fed responded by turning even more hawkish. Now that burst of growth, which was helped by a mild winter and an 8.7% cost-of-living boost to Social Security benefits, is looking like the last gasp of pandemic-era fiscal fuel.
Two of the last remaining Covid-era supports for household finances have now hit their end date. Emergency SNAP (Supplemental Nutrition Assistance Program) benefits recently expired. That amounted to a hit of $95 per month for eligible households, or nearly $50 billion per year. Medicaid income limits, suspended at the start of the Covid pandemic, are now returning. That could knock up to 17 million people out of the program over the next year, leaving them to find more costly insurance coverage, a Kaiser Family Foundation analysis finds.
Covid-19 Pandemic-Era Giveaways
It's hard to overstate how pandemic-era fiscal giveaways and ultralow interest rates transformed household finances. Three rounds of stimulus checks, unemployment benefits that were more generous than many paychecks, and expanded child tax credits helped Americans amass $2.3 trillion in excess savings by late summer 2021, a Federal Reserve study found.
An epic mortgage refinance boom cut average monthly payments by $220 for about 9 million families, the New York Fed says. Another 5 million capitalized on lower interest rates and higher home values to take $430 billion worth of cash-out refis.
Another New York Fed study estimates that student loan borrowers saw $195 billion worth of payments waived in the first two years of the moratorium, implying that sum has now grown to around $300 billion.
Fiscal Fuel For Inflation Spike
All of this helps explain why the U.S. economy has held up through 500 basis points of Fed rate hikes — twice the level of tightening that proved untenable in the last cycle. Yet it also explains why the economy has suddenly become much more vulnerable to recession.
That massive boost to savings — even as consumers splurged and paid down debt — mixed with pandemic supply-chain disruptions to set off an inflationary chain reaction. Because consumers had so much spending power, businesses held the pricing power to afford hefty wage hikes and still reap unusually wide profit margins.
Hiring remained strong because wage hikes helped to sustain robust demand. Plus, households gradually began to spend down their extra savings, piling up credit card debt amid high inflation and fast-rising interest rates.
Finally, to start 2023, the biggest inflation outbreak in four decades produced the biggest Social Security cost-of-living increase since 1981. At the same time, employers coughed up one more round of outsized pay hikes as the labor market remained tight.
U.S. Economy Sees Consumers Pull Back
Yet that cycle has now likely run its course. The consumer already pivoted in the fourth quarter of 2022. The urge to splurge drove the savings rate down to 3% of disposable income by September 2022 from close to 9% before the pandemic, boosting consumption by about $1 trillion at an annual rate. But caution then started to creep in, raising the savings rate to 4.1% of disposable income by April.
Even so, William Blair economist Richard de Chazal figures that consumers already have spent more than 75% of their excess savings haul during the pandemic.
Retail sales, after a COLA-flavored income bounce to start the year, have trended lower over the past three months, slipping about 1% in April vs. January's level. Walmart and Home Depot, which both announced big minimum-wage hikes early in the year, have seen consumers take a step back. Walmart CFO John Rainey cited the end of emergency SNAP benefits and smaller tax refunds as contributing factors.
Businesses Change Spending Plans
Businesses have pivoted too. Corporations announced 337,000 planned layoffs in the first four months of 2023, according to the Challenger, Gray outplacement firm. That's up more than 300% from the same period a year earlier. Labor Department data shows that the number of job openings sank by 1.6 million in Q1. That's the biggest fall in data back to 2001, excluding the April 2020 hit during the Covid-19 pandemic lockdown.
The National Federation of Independent Business' small business optimism index is at the lowest level in more than a decade. Nearly one-third of small firms say they're dependent on bank credit at a time when short-maturity loans come with an average 8.5% interest rate, up 5 percentage points from March 2022.
As demand slackens and pricing power ebbs, high borrowing costs likely will push small businesses to cut their biggest expense: labor.
Businesses "are responding to a 500 (basis point) increase in interest rates over the past 14 months, which alone usually would be enough to push the economy into recession, but they now face a credit crunch too," wrote Ian Shepherdson, chief economist at Pantheon Macroeconomics.
Shepherdson takes issue with Fed hawks eyeing further rate hikes because inflation isn't coming down fast enough. Not only has the Fed done enough, he says, but a failure to cut rates very soon "will amount to overkill."
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Can U.S. Economy Avoid A Hard Landing?
A case can still be made that the U.S. economy is headed for a soft landing. While pandemic-era government supports may be on their last legs, infrastructure spending and business investment are enjoying a growth spurt. Three big spending packages approved under President Biden could plow $1 trillion into earthmoving projects over a decade.
However, Jefferies' Simons doubts that the ramp in spending on infrastructure, chip plants and green energy projects will come fast enough before consumption fades and layoffs pick up.
Yet others argue that consumer finances look plenty strong to keep the U.S. economy on track.
Despite hand-wringing over a rise in credit card debt, "Households are having no trouble servicing their debt," wrote Doug Peta, chief U.S. investment strategist at BCA Research.
"We do not see any credit obstacles preventing households from sustaining their consumption growth" by taking on more debt, Peta said.
Yet the end of the student-loan moratorium could be a game-changer for consumers, while deepening problems for banks. Even without student-loan obligations, credit card and auto-loan delinquency rates have climbed back to pre-pandemic levels, New York Fed data shows.
Delinquencies are highest for younger borrowers, who are more likely to hold student loans in forbearance. Once those payments resume, delinquencies may spike.
Student-Loan Wildcard
The unknown fate of student-loan relief complicates the outlook for the U.S. economy and the stock market.
Even if the Supreme Court strikes down student-loan forgiveness, the White House has a backup plan. The Congressional Budget Office estimated that Biden's Plan B, limiting repayment based on income, would cost the government $230 billion.
Under the plan, student loan borrowers would have to pay no more than 5% of income above about $33,000 per year, down from 10% under current law. That would surely minimize the economic hit once the moratorium ends. However, this relief plan also could get tangled in a legal fight if the Supreme Court rules against Biden's loan forgiveness.
Stock Market Rally Faces 'Liquidity Storm'
With hopes for a debt-ceiling deal and blockbuster earnings from artificial-intelligence play Nvidia lifting the stock market, the S&P 500 ended last week at its highest close since August.
Yet investors should be on guard for a stock market pullback, if history is a guide. The S&P 500 rallied a few weeks ahead of the 2011 debt-limit deadline. But the stock market turned down ahead of the deal, and the sell-off continued as the ink dried. The S&P 500 dived more than 10% in two weeks surrounding the Aug. 2 debt ceiling deal.
A replay of that stock market sell-off is far from certain, since debt-ceiling negotiators didn't need a push from financial market stress to reach a compromise. The rally in artificial intelligence stocks also might have legs.
Still, investors have reason to worry that the immediate aftermath of a debt-ceiling deal might not be pretty, as the dam on Treasury issuance bursts.
For regional banks competing with high bond yields as they try to minimize deposit flight, the coming increase in Treasury issuance "is likely to make things worse," Simons wrote. That risks a further tightening of lending standards.
Barry Knapp of Ironsides Macroeconomics told clients in a May 23 audio note that he sees the S&P 500 falling as low as 3,850 as the reprieve from Fed quantitative tightening abruptly ends.
"We're on the verge of what we would describe as a liquidity storm," he said.
