If the US defaults on debt, expect the dollar to fall

 

 

 

Congress has seemingly kicked the debt ceiling deadline down the road – but the threat of a future default still exists.

Lawmakers in the Senate agreed to extend the government’s ability to borrow until December. It came after Senate Minority Leader Mitch McConnell offered a temporary suspension to the debt limit, averting a default until at least December. But at that point, Democrats would have to find a way to raise the debt ceiling on their own – something they’ve said they won’t do.

This isn’t the first time Republicans have resisted helping a Democratic president raise the debt ceiling.

As an economist, I know that this political game of chicken has real-life consequences – even if it doesn’t end with default. In August 2011, during the Obama administration, brinkmanship over the debt ceiling led to an unprecedented downgrade of the United States’ credit rating, which caused markets to plunge.

What is national debt?

Understanding those consequences begins with looking at how the U.S. government finances its spending. The Treasury Department has three sources.

It can use revenue from taxes and fees approved by Congress but collected by the Treasury.

It can also print money through the Federal Reserve.

But when the first two options don’t supply enough cash to pay the bills, the Treasury can borrow the difference by issuing bonds and selling them on the world’s financial markets. Bondholders lend the government a set amount of money to be paid back with interest over a certain time frame. The amount owed is the national debt, which currently stands at US$28.43 trillion. That is above the debt ceiling of $28.4 trillion set by Congress earlier this year. The Treasury had been using “extraordinary measures” to finance government spending in lieu of an extension, but those measures were due to expire within weeks.

Although this includes money due to lenders and investors both overseas and in the U.S., a sizeble chunk is money that the federal government owes itself – the U.S. Treasury owes money to other parts of the government as part of an accounting procedure. The Fed buys Treasury bonds when it wants to increase the supply of money in the economy and currently owns around one-fifth of the Treasury debt. The Social Security Administration holds around $2.9 trillion in national debt, which is financed with surplus revenue.

Among the largest nonfederal institutions that hold Treasury debt are private pension funds.

Altogether, the Federal Reserve, government and nongovernment pension funds hold about half of U.S. national debt.

What happens if the U.S. defaults?

If Congress doesn’t suspend or raise the debt ceiling, the government would not be able to borrow additional funds to meet its obligations, including interest payments to bondholders. That would most likely trigger a default.

The knock-on effect of the U.S. defaulting would be catastrophic.

Investors such as pension funds and banks holding U.S. debt could fail. Tens of millions of Americans and thousands of companies that depend on government support could suffer. The dollar’s value could collapse, and the U.S. economy would most likely sink back into recession.

And that’s just the start. The U.S. dollar could also lose its unique place in the world as its primary “unit of account,” which means that it is widely used in global finance and trade. Without this status, Americans simply wouldn’t be able to maintain their current standard of living.

A U.S. default would set off a series of events, including a depreciating dollar and surging inflation, that I believe would likely lead to the abandonment of the U.S. dollar as a global unit of account.

The combination of all this would make it a lot harder for the U.S. to afford all the stuff it imports from abroad, and with it Americans’ standard of living would fall.

 

U.S. may be barreling toward recession in next year, more experts say

 

The U.S. economy could be heading for a recession in the next year, 

 according to growing warnings from banks and economists, as a sudden bout of pessimism hammers financial markets, which on Thursday spiraled further from recent highs.

Although major swaths of the economy — including the job market and consumer spending — remain robust, there are mounting worries that rising borrowing costs for consumers and businesses, after years of near-zero interest rates, could cause a sudden retrenchment. The Federal Reserve has raised interest rates by 0.75 percentage points so far this year, while officials are signaling more aggressive increases could be necessary to cool the economy. Continued uncertainty from the coronavirus pandemic and Russia’s invasion of Ukraine are adding to the uneasiness.

Financial markets fell again on Thursday, a day after the Dow Jones industrial average suffered its worst drop of the year. The S&P 500 inched further into bear market territory — defined as a 20 percent drop from the most recent peak — after Wednesday’s sell-off wiped out more than 4 percent of its value.

“Recession risks are high — uncomfortably high — and rising,” said Mark Zandi, chief economist at Moody’s Analytics. “For the economy to navigate through without suffering a downturn, we need some very deft policymaking from the Fed and a bit of luck.”

This week alone, former Goldman Sachs chief executive Lloyd Blankfein warned of a “very, very high risk” of recession; Wells Fargo CEO Charlie Scharf said there was “no question” that the U.S. economy is heading toward a downturn; and former Fed chair Ben Bernanke cautioned that the country could be poised for “stagflation” — a slowing economy combined with high inflation.

Those concerns come amid a smattering of data that points to economic cooling, particularly in interest-rate-sensitive sectors that are already feeling the brunt of the Fed’s promise to keep tightening monetary conditions. New home construction slowed in April. Mortgage demand continues to decline.

 Some of the country’s largest and most influential retailers reported disappointing sales and profits this week because of higher costs and overstocked inventory issues, engineered to avoid supply chain disruptions, setting off a stock market meltdown. Walmart stock plunged more than 11 percent on Tuesday, its worst one-day loss in 35 years. On Wednesday, Target shares tumbled 26 percent, following a stunning 52 percent drop in quarterly profits, which executives attributed in part to cooling demand for big-ticket items such as TVs, kitchen appliances and outdoor furniture.

“While we anticipated a post-stimulus slowdown in these categories … we didn’t anticipate the magnitude of that shift,” Brian Cornell, Target’s chief executive, said in a Wednesday earnings call. “When we talk to our guests, they often express their concerns about a host of rapidly changing conditions, ranging from geopolitics to the high and persistent inflation they’ve been experiencing.”

Goldman Sachs this week revised down its forecast for second-quarter U.S. economic growth, to an annualized rate of 2.5 percent, citing higher prices and continued supply chain disruptions. That follows an unexpected contraction in the first three months of 2022, when the economy shrank at a 1.4 percent pace, mostly because of a trade imbalance and a drop in inventory purchases.

International turmoil, including a risk of recession in Europe and China, is dimming the outlook for the U.S. economy. And a strengthening U.S. dollar — as rate increases make dollar investments more attractive — could dampen exports, raising the chances of a technical recession in which the economy contracts for two quarters in a row.

That fear of a souring economy as well as shifts in consumer pandemic spending habits have led some highflying tech darlings including Netflix and Peloton to announce layoffs in recent weeks. Twitter and Meta have paused hiring plans, while Amazon executives recently said the company was “overstaffed” after months of brisk hiring. National claims for unemployment insurance inched up to 218,000 last week, a four-month high although still near historic lows.

 

Meanwhile, inflation, which remains near 40-year highs, has become a central challenge for both the economy and the Biden administration. Higher prices for basics like food, energy and housing are straining Americans’ budgets and clouding their view of the economy. Gas prices soared to yet another all-time high this week, with average prices hitting $4.57 per gallon nationwide. A closely watched consumer sentiment index by the University of Michigan shows that Americans’ views of their current finances and future expectations have fallen sharply in the past year.

Despite that gloomy outlook, Americans continue to spend heartily. Sales of clothing, cars and furniture all ticked up in April, contributing to a 0.9 percent increase in overall retail sales from a month earlier, according to Commerce Department data released this week.

 

“Near term, the U.S. economy is holding up rather well despite the trouble abroad and the high prices at the checkout stand,” said Beth Ann Bovino, chief U.S. economist for S&P Global, who says there’s a 35 percent risk of recession in the next year. “People are spending, businesses are still trying to hire. But there are certainly challenges ahead. The Fed’s actions will slow the economy, but the question is whether they could also topple the apple cart.”

A day after warning that slower growth and inflation are “having stagflationary effects,” Treasury Secretary Janet L. Yellen said Thursday she is optimistic the central bank could contain inflation without causing a recession. But she acknowledged that the ability to do so was far from clear.

“I think it’s conceivable there could be a soft landing. It requires both skill and luck … I hope that’s the case, but this is a very difficult economic situation,” Yellen told reporters in Germany, citing economic shocks from the war and sanctions on Russia. “There’s a lot going on. … It’s not a straightforward matter.”

 

Even if the United States staves off a recession in the short term, some economists say the sheer pace of inflation, with prices up 8.3 percent in the past year, and the persistent supply-and-demand imbalances caused by the pandemic, and the policy responses to it, could snowball into an even more severe crisis down the line.

“Consumers are spending like crazy, businesses are going to need to rebuild their inventories, and a lot of workers are still flowing back into the labor market,” said Jason Furman, an economics professor at Harvard University who served as an adviser during the Obama administration. “But all of this makes me worry about one or two or three years from now — because it might mean the Fed needs to raise rates even more, and it might mean you create an even bigger recession later.”

Zandi, of Moody’s, said rising gas and commodity prices from pandemic-related supply chain snarls and the conflict in Ukraine have added to the specter of an economic downturn. He now puts the odds of a U.S. recession in the next 24 months at about 50 percent.

“We’re traveling very close to the edge,” he said. “The housing market is the next thing that’s going to roll over; the question is just how hard.”

New home construction fell in April, led by a slowdown in single-family homes. Building permits, which offer a glimpse into future construction, also declined, according to data released this week by the Census Bureau and the Department of Housing and Urban Development.

“Home builder sentiment fell to the lowest level in two years in May,” Yelena Maleyev, an economist for Grant Thornton, said in an analyst note. “Builders are seeing less foot traffic and expect sales to be softer as we enter the busy home-buying season.”

That softening is already rippling through the economy. Major mortgage lenders across the country, including Wells Fargo and Better.com, have laid off thousands in recent weeks as a result of dwindling demand for home loans and refinancing.

In Alexandria, Va., mortgage lender Kevin Retcher said there is a discernible skittishness among potential home buyers. Refinances began tumbling late last year, around the time the Fed began signaling upcoming rate increases. In the months since, a combination of rising mortgage rates — now at 5.3 percent for a fixed-rate 30-year mortgage, nearly double early 2021 levels — and sky-high home prices have begun deterring buyers, he said. At least three clients have gotten “cold feet” and pulled out of ratified contracts in the past two weeks, he added.

 

“There is an extreme sense of nervousness out there,” said Retcher, president of First Meridian Mortgage. “It’s rare to have people win contracts and then back out, but that’s what’s been happening.”

Other types of small businesses say they’re seeing a pullback in consumer demand, too, as customers grapple with rising costs. Aaron Mulherin, who owns a glass repair company in Marion, Iowa, said that while homeowners are continuing to pay for necessities such as fixing broken windows, they’re starting to think twice about spending on luxuries such as custom showers.

“Average, middle-class consumers are starting to hesitate,” Mulherin said. “Everything is getting more expensive, so they’re getting an estimate, then putting it off.”

 

 

The US economy is ‘nowhere near a recession this year,’ says an economist—but 2023 is a different story

 

With turmoil in the markets, high inflation and impending interest rate hikes that will make borrowing money more expensive, many Americans are wondering if the economy is heading toward a recession.

Goldman Sachs chairman Lloyd Blankfein said last weekend that “it’s certainly a very, very high risk factor,” and consumers should be “prepared for it.” However, he hedged his comments by saying the Federal Reserve “has very powerful tools” and a recession is “not baked in the cake.”

Although it is impossible to know for sure, the odds of a U.S. recession in the next year have been steadily rising, according to a recent Bloomberg survey of 37 economists. They have the probability pegged at 30%, which is double the odds from three months ago.

To put that number into context, the threat of a recession is typically about 15% in a given year, due to unexpected events and numerous variables.

The bottom line: “The likelihood of recession this year is pretty low,” says Gus Faucher, a chief economist at financial services company PNC Financial Services Group. However, “it gets dicier in 2023 and 2024.”

What determines whether the economy enters a recession

A recession is a significant decline in economic activity that is spread across the economy and lasts more than a few months, according to The National Bureau of Economic Research, which officially declares recessions.

A key indicator of a possible recession is the real gross domestic product (GDP), an inflation-adjusted value of the goods and services produced in the United States. For the first time since early in the pandemic, it decreased at an annual rate of 1.4% in the first quarter of 2022. Since many economists agree that 2% is a healthy annual rate of growth for GDP, a negative quarter to start the year suggests the economy might be shrinking.

Another factor is rising inflation, which has recently shown signs of slowing down. But it’s still well above the Fed’s 2% target benchmark, with a year-over-year rate of 8.3% in April, according to the most recent Consumer Price Index numbers.

With a high rate of inflation, higher prices outpace wage growth, making things like gas and rent more expensive for consumers. For that reason, the Fed imposes interest rate hikes, as they did in March and May, with five more expected to follow this year. These hikes discourage spending by making the cost of borrowing money more expensive for businesses and consumers.

While many economists still expect the GDP to grow in 2022, the rate by which inflation is decreasing is less clear.

Signs of economic strength

However, there are positive economic indicators to consider as well. Job numbers continue to look good, as the U.S. economy in April had its 12th straight month of job gains of 400,000 or more. And employment levels and consumer spending remain strong, for now, despite interest hikes and inflation.

“Ultimately, inflation in terms of rising prices needs to work its way into actual spending behavior,” says Victor Calanog, head of the commercial real estate economics division within Moody’s.

He points out that consumer expenditures in the U.S. rose by 2.7% last quarter: “People are still spending more, but at what point will they start spending less?”

Despite these positives, risks remain. The Federal Reserve is walking a fine line with its monetary policy, says Faucher, as doing either too much or too little to control inflation could further hurt the economy.

“Rising interest rates are designed to cool off growth, hopefully without pushing the economy into recession,” says Faucher. But he says that if the central bank “raises their rates too much, that can push the economy into recession.”

“That’s why I’m more concerned about 2023, or 2024, because we’ll have felt the cumulative impact of all of those interest rate increases that we’re going to be seeing over the next year and a half.”

Assessing the Current Risks to the U.S. Economy

  

Russia’s invasion of Ukraine occurred just as pressures in the U.S. economy appeared to be peaking, and the prospects of a soft landing were good. The days, weeks, and months ahead will bring more clarity about how it impacts the U.S. economic cycle. A recession is not a foregone conclusion, and companies should stay flexible, reassessing their outlooks and tactics as events unfold.

 

Before Russia’s Feb. 24 invasion of Ukraine, the outlook for the U.S. economy was stressed but hopeful. Pandemic pressures appeared to be peaking, inflation was widely expected to normalize, and the Fed stood a credible chance of engineering a “soft landing.”

But an enormous humanitarian atrocity in Europe has triggered an unpredictable global financial and economic conflict that will see consequences ricochet. Though new risks have emerged, and uncertainty is higher, at present the main impact of the crisis on the U.S. economy is the exacerbation of existing pressures and risks. The path of inflation, and the policies to contain it, remain the main threat to the cycle. While that risk has gone up, it need not be a recessionary outcome.

How the Stimulus Bet Played Out

As we wrote here last year, policy makers placed an enormous bet at the start of 2021 that extraordinary stimulus would transform a strong recovery into an even stronger expansion. The payoff would be a “tight” economy — one that delivered broad-based real wage gains that firms paid for with higher productivity growth, not by raising prices. A win-win-win for workers, firms, and politicians.

That preferred scenario has not materialized. The tight economy did arrive with strong nominal wage gains and signs of productivity growth. But inflation has grown faster, as firms discovered pricing power and used it widely to protect their profit margins. In February, year-over-year price growth stood at 7.9%, a 40-year high.

But it would be wrong to blame only the stimulus. Inflation was also driven by supply-chain bottlenecks — exacerbated by waves of the virus that interrupted production and slowed inventory recoveries — and a labor market scrambling to hire back workers, while labor supply sluggishly continued to normalize.

Pressures Appeared to Have Peaked

Despite this, there was clear evidence that the U.S. economy had passed peak economic pressure. In product markets, demand was normalizing, even slowing in many overheated areas, such as consumer durables, while inventories were growing. In the labor market, the frenetic pace of hiring had eased, while labor supply was finally normalizing.

February’s job reports, released on March 4, underlined all this. Firms were broadly able to hire workers in large numbers (+654K private payroll), which was facilitated by a continued strong uptick in labor participation. Meanwhile, wage growth, though still high year over year, was flat month over month. All this would have been a bullish signal that the economy remains strong and pressures were easing.

How the War Drives up Recession Risk

Russia’s conflict has made those markers of economic strength nearly irrelevant as higher-order risks are taking center stage. The prospect of sustained conflict and an altered geoeconomic reality have yet to sink in. But it’s not too early to think about how the impact could play out. Is a recession now in the cards?

The impact of an economic shock is delivered through one — or several — of three transmission channels. Let’s see where risks are highest and why.

Financial recessions remain the pernicious kind. They unfold when a shock cripples banks, either through liquidity or capital concerns that force them to deleverage. In their wake, they leave lasting asset price damage, impaired investment plans, and slow recoveries. This was the story of 2008 — but it was successfully averted in 2020.

The U.S. banking system was in strong shape before the war started and continues to exhibit very limited stress. The capital position of U.S. banks is strong, profitability is the best it’s been in years, and liquidity is extremely flush. Exposure to Russian assets is limited, and live data on credit spreads are reassuring.

Yet, there remain unknowns. Banking is an extremely interlinked ecosystem, which can hide vulnerabilities. A novel risk that stands out is a debilitating cyberattack on western financial infrastructure, a clear reason never to dismiss the financial sector as a source of serious surprise.

Real economy recessions are typically milder and driven by sudden demand or supply shocks that can tip an already vulnerable economy into recession. Has the Ukrainian conflict triggered enough headwinds to deliver such a shock? On the negative side of the ledger a few stand out:

• Energy prices (direct effects): In 2021, oil prices in the U.S. (WTI) rose from just below $50/barrel to more than $75/barrel. If prices had stayed there, the impact on inflation (and real incomes) would have waned, as inflation measures the change in prices, not price levels. However in the wake of the Ukraine invasion, prices have reached as high as $130/barrel, i.e. similar price growth to last year’s and hitting real incomes again.
• Energy prices (impact on confidence): Energy prices also have a clear — inverse — relationship with consumer confidence. Consider that confidence didn’t recover strongly in the last expansion until oil prices collapsed throughout 2014. High oil prices flowing through to the gas pump are likely to diminish household confidence.
• Wealth effects: Falling asset prices mean households feel less wealthy and make them pull back from expenditures and save more.
• Supply-chain disruptions: Russia’s invasion is another blow to globally integrated supply chains that have repeatedly gummed up economic output over the last two years.

Despite this litany of headwinds, it’s not clear as of today that they outweigh the tailwinds the U.S. economic cycle continues to experience:

• Growth, though decelerating, has momentum and is running above trend growth in 2022, providing some insulation from shocks.
• Household sector remains healthy, as balance sheets are still very strong across income cohorts, including elevated cash balances.
• Labor markets are very tight, with record job openings, strong hiring, and strong wage gains providing a robust domestic tailwind to continued consumption.
• Firms remain highly profitable and interested in investing, as they look to build resilience and new capacity.
• Direct U.S. trade linkages to Russia and Ukraine are modest overall, and potential disruptions will come as Americans continue to reemerge from Covid shutdowns.

These tailwinds and headwinds are not exhaustive, nor is it possible to confidently net them against each other. But the backdrop of the U.S cycle remains one that suggests the expansion can continue.

A Policy Error Remains the Central Recession Threat

This means the most plausible source of risk remains a so-called policy error recession. Even before the war, a policy error was the key risk to the expansion: Hike interest rates too little or too slowly and inflation may spiral out of control; hike rates too high or too fast and an unnecessary recession occurs.

The war has made the Fed’s high-wire act even more precarious. To get the balance of headwinds and tailwinds right, policy makers have to interpret all the drivers we discussed so far — energy, labor markets, product demand, supply chains, etc. — without having full visibility or timely data. The impact of energy prices, for example, was difficult enough to gauge before the war. Now it’s gotten a lot harder, and so the risk of a policy error is also a lot higher.

Before the invasion, markets saw the Fed delivering seven interest rate hikes through the beginning of 2023 to bring inflation under control. Many observers feared that would be too much for the cycle to survive. Today, the market still sees about seven hikes — basically unchanged despite the massive increase in uncertainty. The key question is not if the war derails the expansion, but if the Fed can negotiate a soft landing with that degree of tightening.

What Executives Can Do

As the shock of the invasion reverberates through the economy and cycle risk builds, executives will strive to position their businesses to minimize impact. Here are a few do’s and don’ts.

• Don’t rely on forecasts as extreme uncertainty prevails; flimsy in the best of times, they remain out of reach.
• Do build the capabilities to analyze and model the transmission of shocks and stress test using scenario planning.
• Don’t assume that shocks deliver structural change – they can, but in the fog of the moment the bar for inflection often appears deceptively low.
• Don’t assume that pricing power persists. As growth moderates and inventories build, firms may well return to defending market share.
• Do think of productivity growth as a sustainable source of competitive advantage.

Russia’s invasion of Ukraine occurs just as pressures in the U.S. economy peaked, and prospects of a soft landing were good. The days, weeks, and months ahead will bring more clarity about how it impacts the U.S. economic cycle. A recession is not a foregone conclusion, and companies should stay flexible, reassessing their outlooks and tactics as events unfold.

 

Danger ahead: The U.S. economy has yet to face its biggest recession challenge

 “The fact of the matter is this gives the Fed additional room to continue to tighten, even if it raises the probability of pushing the economy into recession,” said Jim Baird, chief investment officer at Plante Moran Financial Advisors. “It’s not going to be an easy task to continue to tighten without negative repercussions for the consumer and the economy.”

Indeed, following the robust job numbers, which included a 5.2% 12-month gain for average hourly earnings, traders accelerated their bets on a more aggressive Fed. As of Friday afternoon, markets were assigning about a 69% chance of the central bank enacting its third straight 0.75 percentage point interest rate hike when it meets again in September, according to CME Group data.

So while President Joe Biden celebrated the big jobs number on Friday, a much more unpleasant data point could be on the way next week. The consumer price index, the most widely followed inflation measure, comes out Wednesday, and it’s expected to show continued upward pressure even with a sharp drop in gasoline prices in July.

That will complicate the central bank’s balancing act of using rate increases to temper inflation without tipping the economy into recession. As Rick Rieder, chief investment officer of global fixed income at asset management giant BlackRock, said, the challenge is “how to execute a ‘soft landing’ when the economy is coming in hot, and is landing on a runway it has never used before.”

“Today’s print, coming in much stronger than anticipated, complicates the job of a Federal Reserve that seeks to engineer a more temperate employment environment, in keeping with its attempts to moderate current levels of inflation,” Rieder said in a client note. “The question though now is how much longer (and higher) will rates have to go before inflation can be brought under control?”
More recession signs

Financial markets were betting against the Fed in other ways.

The 2-year Treasury note yield exceeded that of the 10-year note by the highest margin in about 22 years Friday afternoon. That phenomenon, known as an inverted yield curve, has been a telltale recession sign particularly when it goes on for an extended period of time. In the present case, the inversion has been in place since early July.

But that doesn’t mean a recession is imminent, only that one is likely over the next year or two. While that means the central bank has some time on its side, it also could mean it won’t have the luxury of slow hikes but rather will have to continue to move quickly — a situation that policymakers had hoped to avoid.

“This is certainly not my base case, but I think that we may start to hear some chatter of an inter-meeting hike, but only if the next batch of inflation reports is hot,” said Liz Ann Sonders, chief investment strategist at Charles Schwab.

“While economic output contracted for two consecutive quarters in the first half of 2022, a strong labor market means that currently we are likely not in recession,” said Frank Steemers, senior economist at The Conference Board. “However, economic activity is expected to further cool towards the end of the year and it is increasingly likely that the U.S. economy will fall into recession before year end or in early 2023.”