A surprising twist on the debt-ceiling debate
Brinksmanship could have unintended consequences for market conditions.
- By Jurrien Timmer, Director of Global Macro for Fidelity Management & Research Company (FMRCo),
- Fidelity Viewpoints
- – 02/01/2023
- Debt-ceiling brinksmanship could have some surprising unintended impacts on the market.
- There is now broad consensus that earnings for this cycle have peaked, and that we may see at least a few quarters of earnings contraction.
- However, it's also possible that we won't see a trough for earnings for another year, in which case it may be challenging for the market's October 2022 lows to hold.
As January gives way to February, the narrative for the markets this year continues to come down to just a few issues: The Fed, based on its meeting this week, is holding steady to its expected restrictive course—but we still don't know how long it will stay restrictive or how quickly it may reverse course. Will earnings growth hold up? When may recession be coming, and how deep and long may it be? Could debt-ceiling brinksmanship lead to market volatility?
Here is my latest thinking on these questions, and more.
The debt ceiling and markets: A surprising twist
Below is the debt ceiling story in one chart. Note that history shows deficit spending is not actually a partisan issue. Both Republicans and Democrats have overseen continued increases to the country's outstanding debt balance.
The most commonly voiced concern regarding the debt ceiling is that brinksmanship over raising the ceiling could trigger market volatility. But there are actually some surprising potential unintended consequences that could follow from the combination of the current debt-ceiling dynamics, plus the Fed's tightening campaign.
About the expert
Jurrien Timmer is the director of global macro in Fidelity's Global Asset Allocation Division, specializing in global macro strategy and active asset allocation. He joined Fidelity in 1995 as a technical research analyst.
These consequences have to do with the economy's overall liquidity backdrop—meaning, how much cash and cash-equivalents are readily available to market participants.
The chart below shows the Fed's balance sheet (gray) and the Treasury General Account, or TGA (blue). The TGA is often equated to the Federal government's checking account, as it's the account used for depositing taxes, depositing proceeds from sales of debt, and paying most forms of government disbursements.
Note how the TGA spiked in 2020—as the Treasury increased borrowing in anticipation of paying for pandemic relief—at the same time as the Fed grew its balance sheet from $3.76 trillion to more than $7 trillion. Then, the Treasury drew down its TGA balance to pay for COVID stimulus packages.
And here's where we get to the potentially ironic twist regarding the debt ceiling. A political showdown on the debt ceiling would force the Treasury to draw down its $569 billion TGA balance to avoid a technical default on the nation's debt. But drawing down that balance would be stimulative, and would at least partly offset the Fed's overall efforts to restrict liquidity.
For comparison's sake, the Fed is currently engaging in quantitative tightening (the process of shrinking its balance sheet), by about $95 billion a month, meaning that drawing down the TGA balance could essentially offset 6 months' worth of quantitative tightening.
Earnings: Will a trough come into view?
In addition to these liquidity dynamics, earnings are front and center, and the news is not great.
At a cursory level, fourth-quarter earnings season has been OK so far. Out of the companies that have reported, about 70% have been beating estimates, by an average of 2.1%. But based on the increasing pileup of downward revisions (which is when analysts lower their estimates of companies' future earnings), it's becoming pretty clear that this earnings cycle has already peaked. The weekly progression of quarterly growth estimates shows an incoming tide of negative growth numbers.
In my opinion, it looks like the next 2 quarters will be well into negative territory. For calendar 2023, the expected earnings growth rate is now essentially zero. And with all those revisions continuing to come in, it's likely heading lower.
Of course, the bullish counterargument would be that the market already knows all this, has already priced it all in, and is in fact already a few steps ahead of this narrative. Given the 31% decline in price-to-earnings ratios we saw in 2022, it would be fair to argue that a lot has indeed already been priced in.
The problem with the bullish case, in my view, is that an earnings bottom could still be, say, another year away—based on indicators I'm following such as manufacturing orders and the yield curve. The market can look past trough earnings, but only once the trough is near enough to see. And if earnings don't bottom for another year, then the market's October 2022 low may have a hard time holding.
The Fed: Still keeping the course
One more reason why the market may not yet be out of the woods: The Fed is still raising rates and committed to shrinking its balance sheet through quantitative tightening.
As I have written about before, based on expected future interest rates implied in current yield curves, the market is expecting the Fed to reach a peak fed funds rate of about 5% later this year, before quickly cutting rates to less than 3%. But this expectation seems to be at odds with the Fed's repeated public statements that it may stay in the restrictive zone for some time.
One explanation for this discrepancy could be that the market expects the Fed to trigger a hard landing, which would require it to start cutting rates again to support the economy. Some support for this theory comes from another indicator I've been watching, the San Francisco Fed's "proxy effective fed funds rate." This proxy rate seeks to give a more complete picture of how tight or loose the Fed is—based not just on the current level of the fed funds rate but a range of tools in the Fed's monetary toolkit, including variables like quantitative tightening and forward guidance.
That proxy rate is currently at 6.44%, and shows that when one considers the full picture of the Fed's stance, it is already much tighter than what is implied by the fed funds target rate.
Perhaps this is why the market is expecting the Fed to start cutting rates so sharply into 2024. Perhaps the market sees that the Fed is so restrictive that a hard landing may be in store. But if this is true, then it's hard to see earnings holding up.
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