With debt ceiling deal involving billions of dollars of spending cuts and clawbacks of funds, economic growth likely to slow even further. A recession is nearing 

by IFAST RESEARCH TEAM 

AFTER a months-long standoff, the US finally reached a deal that suspends the debt limit — a cap on the total amount of money that the federal government is authorised to borrow via US Treasury securities — through Jan 1, 2025. The Congress passed the legislation on June 3, 2023, just before the X-date (date at which the government can no longer pay its bills) of June 5, thus enabling the US to avoid its first-ever default in history. 

Recession is Still Coming 

The suspension of the debt limit comes with several strings attached. For a start, the US would be required to cap spending in the 2024 and 2025 budgets. Unused Covid-19 funds from areas such as rental assistance, small business loans and broadband for rural areas will be clawed back. The deal will also expand work requirements for food aid programmes, speed up the permitting process for some energy projects, and put an end to the pause on student loan repayments. 

The debt ceiling deal is likely to weigh on economic growth in near term, reinforcing our view that a recession is nearing. Nonetheless, as the US has managed to avert a default, the downturn is unlikely to be severe. 

Elements in the deal, such as the claw-backs of Covid-19 assistance and the reinstatement of student loan payments, could hurt consumer confidence and disposable income. Consequently, consumer spending — which contributed approximately 70% of US economic activity — would be reduced, creating an additional blow on growth. In particular, student loans are the largest source of US consumer debt other than mortgages. Some 45 million Americans owe a total of US$1.6 trillion (RM7.44 trillion) worth of student loans, and many borrowers have credited the pause on student loan repayments as a huge help to get out of debt and recover financially. 

Meanwhile, the US Leading Economic Index — which provides an early indication of significant turning points in the business cycle — continues to flag worsening economic conditions ahead. In April 2023, the index fell by -8% year-on-year, the lowest level since May 2020. It is worth noting that a reading below -4% typically signals that a recession is set to occur. 

Risk of US Downgrade Remains 

Despite the suspension of the debt ceiling that allows the government to meet its obligations, the US remains at risk of a credit downgrade. Fitch Ratings said in a statement that the US will continue to be on negative watch (Table 1). The credit ratings agency believes that repeated political standoffs around the debt limit and last-minute suspensions before the X-date lowers confidence in governance on fiscal and debt matters. Furthermore, DBRS Morningstar — which is the world’s fourth largest credit ratings agency — also placed the US’s issuer rating of AAA under review with negative implications. 

This could become the second downgrade for the US. In 2011, S&P Global Ratings downgraded the US’ rating to AA+ from AAA. It came days after a last-minute debt ceiling deal was reached, subsequently hurting markets and consumer confidence. 

Indeed, a last-minute debt ceiling deal which occurred yet again this month has highlighted the rising polarisation of the US political landscape. This leads to an increasing uncertainty, and has high stakes for the economy and financial markets. It also raises the question of whether the US governance is on par with other sovereigns with triple-A crowns, like Singapore and Germany. It should be noted that the governance shortcomings could have the potential to erode the US’ strengths including the size of the economy, high GDP per capita and dynamic business environment. 

Fitch intends to resolve its negative watch on the US’ rating in 3Q23. Meanwhile, we believe the Treasury yields could move higher as investors demand greater compensation for the risk of another future breach of the debt ceiling. In our view, the 10-year US Treasury yield could soar back towards 4% in the near term, providing investors with an attractive entry point to add duration into their portfolios. 

Finally, the lower a borrower’s rating, the higher the financing costs. In the event of a rating downgrade, borrowing costs would be driven up for the US government, businesses and consumers. This would come at a time when the economy is already at risk of a recession, adding on to market volatility. 

Short-Term Liquidity Squeeze 

Following the suspension of the debt limit, the market is bracing for large issuances (US$1 trillion or more) by the Treasury before the end of the year to replenish its cash balances. There are fears that the influx of investments into Treasury bills (T-bills) could drain liquidity in financial markets as investors would do so using funds invested in other assets. 

Despite this, T-bills are likely to become cheaper due to a significant increase in supply as well as the fact that most money market funds (MMFs) have put a lot of money at the Federal Reserve’s (Fed) reverse repurchase facility (RRP, or reverse repo) that provides an attractive overnight rate of 5.05%. The Fed’s reverse repo facility is designed to provide a floor for short-term rates and the fed funds rates, and takes in cash from MMFs and other eligible firms. In comparison, a one-month Treasury bill — which has a longer maturity than overnight reverse repos — currently only offers a slightly higher yield of 5.14%. 

Positioning Portfolio 

All in all, with the debt ceiling deal involving billions of dollars of spending cuts and claw-backs of funds, economic growth is likely to slow even further and thus we reiterate our view that a recession is nearing. With that being said, we expect further downside and greater volatility across asset markets, particularly equities. In terms of asset allocation, we maintain a defensive positioning, with a preference for fixed income over equities. 

Within fixed income, we prefer investment grade over high yield as a defensive positioning may be more important in a recessionary environment. Duration-wise, we believe that the sweet spot is in short-duration bonds, given their low-interest rate sensitivity and that short-term bond yields have moved significantly higher compared to long-term yields. 

• The views expressed are of the research team and do not necessarily reflect the stand of the newspaper’s owners and editorial board. 

• This article first appeared in The Malaysian Reserve weekly print edition