May 25, 2023
Headlines suggest the two sides remain nowhere near an agreement, with the market-based probability of default at ~25% and rising. After yesterday’s close, Fitch put AAA rated US sovereign debt on watch for a downgrade. Yellen insists her June 1 date is accurate, while others suggest the actual date is a week later. The Treasury would likely prioritize principal and interest payments in the event that no deal is reached. Doing so would avoid a technical default, but would probably still trigger a US credit rating downgrade. The S&P 500 (SPX) fell another -0.7% yesterday, T-bills maturing near the x-date have cheapened considerably and CDS spreads have widened. T-bills maturing on 6/15 are priced to yield 6.1%, whereas bills due on 6/30 yield 5.3%. The T-bill pricing dynamic comes from money market funds avoiding the maturity due to their need for liquidity. Equity markets haven’t fully priced in a potential rating downgrade. Recall the peak-to-trough decline from the 2011 downgrade was ~20%.
The $1.9T in additional Covid relief spending during the spring of 2021 came a month after US manufacturing PMI printed an all-time record high. At the time we compared the unnecessary spending to force feeding a goose in order to make foie gras. Most of the attribution for currently elevated rates of inflation go to the Fed’s delinquent response, but there’s no doubt the additional $1.9T in fiscal spending exacerbated the problem. Cutting fiscal spending reduces aggregate demand and inflation. And cutting fiscal spending when the economy is operating above capacity has little impact on GDP growth.