The Taiwan Banker

Without the increased attention now being paid to the national debt, the US Democratic party might have been more willing to negotiate. Driven by several of its more radical members, the Republican party threatened to shut down the government if its new budget did not pass. The shutdown negotiation process had been completed relatively smoothly several times during the low-rate era. In October, however, for the first time in American history, the House of Representatives voted to remove its Speaker Kevin McCarthy through a motion to vacate. Although it was later reconceived as a partisan position, according to the Constitution, the Speaker is appointed by majority vote over the entire House. By tradition, the minority party typically does not interfere in the affairs of the majority, but this time, the Democrats sided with several Republican “arsonists” in the extreme faction of the party. The Republican party turned upon itself, engaging in a fractious dispute over its new speaker, and by extension its future direction as well. It took 15 elections to settle on a new candidate. Moreover, the final 2024 budget has still not been passed, meaning that the same issues could re-emerge over the course of subsequent negotiations. The rage of the moderate Republicans towards their upstart “Freedom Caucus” colleagues appeared genuine, leading to hopes that a small number of them might defect and cooperate with the Democratic leadership. Mike Johnson, the eventual winner of the leadership contest, leans more toward the far-right faction, but the whole episode nevertheless appears to challenge the previous paradigm of relentless partisanship. At the same time, whatever comes next may not necessarily be any easier. Delayed reactionWhether in foreign, domestic, or monetary policy, since the end of the pandemic, the US has faced an increasing variety of tradeoffs between economic growth and credibility. None of these challenges are impossible to solve, but each will require more discipline and planning than has been demonstrated in the recent past.In many respects, the US economy should be the envy of almost every other country, having just released a 4.9% GDP growth print last quarter. The economy has consistently surprised on the upside: a year ago, Bloomberg economists (somewhat implausibly) predicted a 100% chance of a recession in the next year, driven by the Fed’s rapid hiking cycle. Instead, “immaculate disinflation” without unemployment may still be plausible. Inflation has come down significantly since its heights in 2022, although the “last mile” to the 2% target will take longer.Since the 2008 recession, a number of theories have emerged as to why the US economy might not be as sensitive to large rate swings. Fewer companies hold inventories and need short-term capital, for instance. Moreover, some of the effect of the current higher rates is being manifested as housing inequality, rather than GDP contraction or unemployment. Many fixed-rate mortgage borrowers are locked into their current financing at ultra-low rates under the old monetary policy regime, which will affect labor mobility in the future. For non-homeowners, meanwhile, exploding financing costs are not covered in GDP statistics, except to the extent they filter through to rents.The most important reason the rate hikes failed to translate to a cooler economy is however that short-term rates did not propagate to longer-term rates, until approximately August (Fig. 1). Thus, one could say that the rate hike cycle has only just begun. The real test of the economy, including the debt situation, will start soon.Fig. 1. 10-year and overnight ratesThere are two possible causes for the recent movement. The first is that markets have just now become convinced of the Fed’s commitment to ending inflation, as well as a strength of the economy, requiring a long period of high rates to do so. Supporting this interpretation, the US dollar remains strong, driven by the apparent inability of Asian economies to support rate hikes. Reasoning from a price changeAn alternative explanation, meanwhile, is that the market may be growing more concerned about US creditworthiness in light of higher financing costs. On July 31, the US Treasury announced that it would borrow $1 trillion in 3Q, up $274 billion from its May announcement, presaging the August movement in the 10-year rate. Among other pressures on the fiscal situation, the emerging crisis in the Middle East demonstrates that defense spending is unlikely to come down in the foreseeable future. Furthermore, actions by Japan and China to defend their respective currencies, as well as continuing quantitative tightening at the Fed, will involve selling more dollar-denominated bonds into the open market.On November 10, Moody’s, the last of the three major credit agencies to give US sovereign debt a perfect Aaa rating, changed its outlook to negative, citing a “lack of an institutional focus on medium-term fiscal planning.” It assessed that while the economic fundamentals, including economic strength, and institutions and governance strength of the US have not materially changed, its fiscal or financial strength, including debt profile, and susceptibility to political event risk have.Thus, there may be more riding on the ability of the US economy to maintain normal growth than usual, both for global economic growth and the sake of its own debt profile. Overall, market observers expect continued outperformance. This optimism may be because having been burned once, they are unwilling to doubt the resilience of this business cycle.Bad vibesIt is worth noting that despite the strength of directly measurable indicators, domestic perceptions of the economy are strikingly negative, to the extent of causing political problems for President Joe Biden, whose re-election campaign will wind up soon. The Economist magazine recently quantified the so-called “vibecession,” finding that ever since the pandemic, consumer sentiment has been consistently far more negative than the usual indicators would warrant.Theories for this phenomenon abound. The housing situation mentioned above likely plays some role, although the approximately 35% of the population with existing mortgages from the low-rate era has seen windfalls from a net worth perspective. Consumers may simply be reacting to inflation which many have never seen in their lifetimes, and may have a lagged perception of the disinflation which has already occurred. At the same time, the tech industry has been particularly hard, with disproportionate media reach.Economist Joseph Politano also notes that while real wages have increased overall (although at a slower rate than usual), within each individual industry they have declined, with the difference being made up by labor flows to higher-paying industries. Based on this pattern, it might seem reasonable for people to attribute negative economic trends to the economy, and positive trends to one’s own unique skills and initiative. In fact, one of the most important benefits of a hot economy is the ability to move labor into higher-productivity sectors.The important question regarding economic narratives is whether people might in fact be observing the early signs of a recession. Risks appear to be growing in corporate debt, particularly commercial property, which has never recovered from the pandemic. Banks may see continued stress, following the large failures earlier this year. Households are also feeling more pressure than before. “We are seeing emerging signs of stress for households with lower credit scores, and individual borrowers may struggle with debt burdens in the face of economic hardships,” said Fed Governor Lisa Cook in remarks on November 6. Taking in the full picture, Q4 is unlikely to match the results of Q3.The economic is politicalLarge spending programs make up a major part of President Biden’s domestic agenda. The $1.9 trillion American Rescue Plan, as well as $3 trillion in spending on infrastructure investment, ensured that the US was able to rebound quickly from the pandemic, unlike most other major economies, however this expansionism will be more difficult to sustain in the current overheated environment. Extension of pandemic-era student debt forgiveness policies has also become an issue of personal importance for many younger voters.The upcoming presidential election (which also includes House representatives and some senators) will be the first since the January 6, 2021 Capitol riots. It may mark the beginning of a new style of co-existence between the two parties. In the past, Democrats could agree with tax cuts, while Republicans could agree on spending initiatives, thus taking the edge off bitter disputes while constantly increasing the deficit. Now, new sources of leverage will need to be found for negotiation.