Macro Outlook Retakes Spotlight | Seeking Alpha

Transcript

We think the U.S. debt ceiling deal removes a big near-term risk. But the deal will likely now thrust the market’s focus back to the underlying macro and debt backdrop.

We don’t see major central banks coming to the rescue with interest rate cuts this year, and we see rates staying higher for longer.

And we expect attention to turn to the broader government debt position in this new macro regime.

Here’s why:

1) What the debt deal means for inflation

We think an extremely tight labor market is the key factor keeping core inflation high.

And the spending cuts in the debt deal aren’t big, so they won’t stop that overheating. The Federal Reserve will have to keep interest rates high to bring inflation down.

2) Growing debt in the new regime

Higher rates mean higher debt servicing costs for the U.S. government.

And government spending has already well surpassed tax revenue by historical standards.

3) Risks for government bonds

We have long said that higher borrowing costs and heavy debt loads could cause investors to demand more compensation for holding long-term Treasuries.

And an influx of new Treasury bills to replenish government funds could add to volatility, especially for very short-dated bonds.

We expand our preference for short-term bonds to encompass two-year Treasury notes.

We also like investment-grade credit, emerging market local currency debt and inflation-linked bonds.

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Last week’s U.S. debt ceiling deal removes near-term uncertainty and thrusts the market’s focus back to the macro picture: sticky inflation due to tight labor markets. We see rates staying higher for longer as a result. We keep a quality tilt in portfolios and prefer income for now. Over time, we could see the attention shifting to the large U.S. debt load – and investors demanding more compensation for holding long-term government bonds.

Debt dilemma

Notes: The left chart shows total public debt and the right chart shows the U.S. federal government budget balance, both as a share of GDP.

The U.S. debt ceiling deal has taken the near-term risk of default off the table. Yet, the fiscal situation remains challenging, in our view. Total public debt as a share of GDP has jumped to around double the level in 2005 (top chart). The budget deficit is also already large (bottom chart) at a time when the economy is overheating. The debt deal doesn’t really change this picture, we think. The spending cuts are a fraction of what was cut in the last debt ceiling showdown in 2011: about 0.3% of GDP, according to the Congressional Budget Office, compared with 1% in 2011. We don’t see spending cuts dragging on growth in the same way as a result. But we do think higher-for-longer interest rates will raise debt servicing costs and could leave debt levels growing in this new macro regime. We have said the market focus would move back to the macro picture after the debt ceiling deal – now the Federal Reserve and stubborn inflation are retaking the spotlight.

The pandemic shocked U.S. labor supply, creating worker shortages. The labor market remains extremely tight, as confirmed in the latest payrolls data, with workforce participation not having improved. That is keeping core inflation sticky. This has presented the Fed with a sharp trade-off: crush growth with even higher rates or live with some inflation. We think the Fed will have to keep policy tighter. Markets have already started to mull the possibility of another rate hike even after the Fed signaled a potential pause. Markets are no longer pricing in repeated Fed rate cuts, waking up to our long-held view that rates are likely to stay higher for longer to combat persistent inflation.

High debt in the new regime

Attention could also eventually shift to the broader U.S. fiscal position with rates staying higher, in our view. The relatively smaller spending cuts in the U.S. debt ceiling deal aren’t likely to put a dent in the debt load, in our view. They stand in stark contrast with the aftermath of the 2008 financial crisis when the focus swiftly shifted to fiscal austerity. Interest rates were near-zero then, and debt servicing costs were at record lows. But now rates have jumped in the fastest rate hiking cycle since the 1980s.

Higher rates mean higher debt servicing costs. We think persistent inflation and high debt levels could cause investors to demand more compensation for holding U.S. assets over time, especially long-term Treasuries.

We also expect a burst of Treasury bill issuance as the government seeks to replenish the money drawn down since the debt ceiling was hit earlier in the year. We estimate bill issuance could balloon to as much as $1 trillion in the next few months – well above normal issuance levels outside of past crises like the 2008 financial crisis and the pandemic. That could add to volatility in fixed income, in our view, especially in the very short-dated maturities. We tweak our preference for short-term Treasuries as a result, extending the preferred maturities beyond short-term paper to encompass two-year Treasury notes that have repriced in recent weeks.

Bottom line

The U.S. debt ceiling deal removes near-term uncertainty – we now expect markets to focus on the macro picture. We see higher-for-longer rates, so we keep our quality tilt in equities and bonds and prefer income for now. We like short-term Treasuries, emerging market local currency debt and inflation-linked bonds.

Market backdrop

U.S. stocks climbed to 2023 highs after the debt ceiling deal. Yields rose as markets eyed more rate hikes after Friday’s payroll report showed a jump in new jobs. The number of jobs added in May was well above market expectations. But the unemployment rate rose, with no improvement in labor force participation. We don’t think the labor shortage is easing, so wage growth remains elevated. We think that will keep core inflation sticky – and makes rate cuts this year unlikely.

China macro data is in focus this week as the restart loses steam. We now expect GDP growth to be a bit below 6% this year rather than slightly above as momentum slows and policy reactions remain uncertain. Deflationary pressures and weaker growth increase the odds of potential policy easing, but we think targeted support for sectors like real estate is more likely.