Yes, we have banking problems. No, this is not 2008. It's much more like the 1970s S&L problems. In other words, we do not have credit problems today, we have duration (maturity length in portfolios of the banks) problems. These are exacerbated by the fact that QE during COVID inflated total deposits in the banking system. So this is the progression we are dealing with:
- During COVID the Fed showered the economy with over $5 Trillion in capital.
- The capital had to go somewhere. The people, businesses, and general populace got it and had to put it somewhere.
- It went to the banks.
- The bankers had to invest it, so they did, but not the way they should have.
- They invested with too long of a duration in their portfolios.
- COVID taught people many things about how they could still live their lives, but the one that the banks had not counted on was that depositors really didn't need "branch banking" anymore.
- Interest rates spiked and savings and checking account interest rates did not.
- A huge number of people pulled their deposits from the banks and bought US Treasuries and other FDIC-insured instruments on their own.
- Banks had to sell the portfolio of improperly invested duration portfolio and wham, real losses happened.
In the 1970's the Fed held interest rates too low for too long. Today, in some ways we are facing the same problems. Between 2008 and 2021, the Fed held the fed-funds rate at close to 0% for nine years, and below the rate of inflation most of this time. At the same time, because of the above-mentioned QE and COVID and then you throw in a financial panic in 08-09 and we have US Government debt that has grown massively. These deposits are commonly termed "M2 Money Supply." Finally, in the last year, M2 has contracted by 4.1%, the fastest drop the US has experienced since the Great Depression! But even so, it still stands a bit above $5 Trillion. Since there is so much cash sitting in short-term time deposits inflation is likely to remain elevated this year and the Fed is unlikely to cut rates anytime soon.
The end of the story is not written. We fully expect more banking kerfuffles. But just as before, we expect the issues to be dealt with by Government policy and the can to be kicked down the road. What could change things? Economic strife/recession. Fed Chairman Powell seems fixated on labor and labor rates, even when the CPI rate has been declining EVERY MONTH since November 2021. Looking at last week's numbers, the unemployment rate fell to 3.4%. It was expected to come in around 3.6%. Clearly a level of labor participation greater than the expectation and also clearly not a nudge to Powell to stop raising rates much less cut them. He alluded to a possible halt in rates for June, awaiting the signs of 10 rate hikes in a row and their expected effect on the economic engine. It is almost beginning to seem like the media dialed in public sits on pins and needles awaiting every new reading on the state of inflation. This week we get a couple more.
The Debt Ceiling Debate
Time is running out for Congress to raise the debt ceiling. The need to increase the debt ceiling has emerged as the top issue in DC. The Congressional deadlock took on new urgency last week when Treasury Secretary Janet Yellen surprised markets and political leaders when she put out a statement that the X-date for Treasury funding may be as early as June 1. This leaves less than three weeks for Washington to find an exit strategy for the government hitting the statutory debt ceiling.
Two weeks ago, House Republicans eked out a one-vote victory in a bill on their debt ceiling/spending plan. The bill was a move by Speaker McCarthy to get President Biden to sit down to try to negotiate a budget and debt ceiling deal. The Republican House legislation would increase the debt ceiling by $1.5T or until April 1, 2024, whichever comes first. In order to get fiscally conservative Republicans to vote for the bill the proposal cuts over $4.5T in spending over 10 years.
The House passage of the debt ceiling bill achieved Speaker McCarthy’s main goal of getting talks started with the White House when President Biden invited the Speaker and the other Congressional leaders to the White House on Tuesday of this week. The meeting will be the first head-to-head talk between the Speaker and the President on the debt ceiling since February. While the Senate leaders have been invited, Senate Republican Leader McConnell has been clear that for the time being he and his Senate Republican colleagues will follow the lead of Speaker McCarthy and the House Republican majority.
The political reality is that the final debt ceiling bill will require some House Republicans to vote YES and at least nine Senate Republicans to vote to invoke cloture and bring the bill up for a vote. It is a very tough vote for many Republicans to vote to increase the debt ceiling. Speaker McCarthy was able to get nearly all the fiscal hawks to vote for his $1.5T increase only because it had $4.5T in cuts, and everyone knew it was a “message” bill to get President Biden to the table to negotiate. The challenge the White House and Republican leaders face can be seen in the vote back in 2019 when President Trump worked with Congress to increase the ceiling. The Trump-supported bill slowed the rate of spending growth and suspended the debt ceiling for two years, until July 2021, in order to remove the toxic debt ceiling issue from 2020 politics.
But look at the votes on the Trump debt ceiling bill: in the Senate, the Republican leadership worked with President Trump to get the bill passed. On the Republican side, 133 Republicans voted NO. To get a bill passed this year only four Republicans can vote NO, and that assumes every Democrat will vote YES. There are five Democratic House members who represent Republican districts that Trump carried in 2020, and they may tell the leadership that they are a NO vote on the debt ceiling bill. Passing the debt ceiling bill will likely require support from at least two dozen House Republicans.
This week, all attention will be on the White House as Biden and Congressional leaders meet. President Biden has a long career in Washington of finding compromises; the debt ceiling talks will be a big test for that experience. I believe that it will be solved but not before ample amounts of consternation as neither party wants to do anything to lose their voting constituency for the 2024 election.
This note is much shorter than the others as there is not much new to share. At the end of last week, the scorecard for the earnings are as follows:
This doesn't smell like a recession………….yet. Time will tell. But at this point, it appears that the huge amount of cash on the sidelines is still overshadowing the negative effects of the rate increases, the banking crisis, and now, the debt ceiling. I have gone into greater detail this week on the debt ceiling as I feel it is important to understand what the landscape appears to look like. We will move beyond this, but there could be a high level of volatility in the markets given that this is an “unknown.” And we all know what the market thinks of unknowns.
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