Market Commentary: On the Brink Again

by Gayl Mileszko

During times like these, certain words and phrases in the American lexicon are taken out of the mothballs and tossed about by network anchors, editorial boards and political pundits. Impasse. High stakes. Brinksmanship. Loggerheads. Posturing. Crisis. Deadlock. Gamesmanship.

Closer to the X- Date

We are near the peak of another debt ceiling drama, one that will keep the world on edge for several more weeks. In the back rooms and basements of federal buildings throughout Washington, away from the principals and cameras, the proverbial frenzy of negotiations is underway. History repeats itself again with a new cast. Staffers are going back and forth with trial balloons and what-ifs as the clock ticks toward the X-Date. Newscasts feature a lot of pearl-clutching, mailboxes fill with bombshell predictions, fingers point, feet dig in and doomsday plans are dusted off right up until the point that a compromise is announced. There are only three weeks left, maybe four or six — but not much more unless a tsunami of second quarter estimated tax payments arrives on June 15. Most likely there will be a short-term extension passed by voice vote as soon as scribes can fill in the blanks on the draft resolutions kept on the shelf for such occasions. And the can gets kicked down the road once again.

The 14th Amendment

The validity of U.S. debt authorized by law shall not be questioned according to the 14th Amendment to the Constitution. But indeed, it is now once again a concern of many holders of and investors in U.S. Treasury bonds. It has been in fact been questioned during many of the 100 times since World War II that the debt ceiling has been suspended, or lifted. Revisions have been made with or without contentious debate 78 times since 1960, and every President since Herbert Hoover has had to grapple with the cap. In fact, as CNN has reported, the U.S. has been in debt and arguing about it for its entire existence. There is reportedly only one year in which the U.S. had no debt: 1835, during the administration of President Andrew Jackson.

Facing the Prospect of a Default, However Unlikely

Right now, the mere prospect of a default has made it more expensive to insure Treasuries than the bonds of nations that have defaulted many times, including Brazil and Greece. A payment default for even a day would send shockwaves across global financial markets and have a domino effect on the ratings and prices of U.S. government agency, corporate, and municipal bonds. Then it would spread to sovereign debt. If America can’t or won’t pay its debts, what about England, France, Germany, Texas or Maryland? China and Japan currently hold $7 trillion of our debt. Would one or both suddenly put all their T-Bills and T-Bonds up for sale? Could the Federal Reserve take it all back at par? Would American households scrounge up enough patriotism and cash to buy it?

Risking a Downgrade but Banking on a Compromise

Headlines have turned attention from the stability of regional banks, the prospect of more rate hikes, and the expiration of COVID restrictions, including Title 42 which placed curbs on migration un the name of protecting public health. Some of the talk and speculation is about whether the credit of the United States, the benchmark for all other securities, will be downgraded as a result of a delay in action on the debt limit. S&P knocked it down by a notch to AA+ after the contentious debt limit debate in 2011, citing uncertainty in debt growth dynamics. Others place focus on the wide number of back-up plans available to the Administration should there be no timely agreement with Congress on the suspension, increase or elimination of the debt limit. These range from strict reliance on constitutional authority to having the Treasury mint a $1 trillion platinum coin to increasing gold certificate deposits at the Federal reserve. Other proposals include selling the Fed an option to purchase $2 trillion of government property, having the Fed simply destroy $2 trillion of the government bonds it holds, replacing maturing bonds with high premium bonds, issuing perpetual bonds, or prioritizing debt service over all other payments and meeting other obligations as revenue rolls in. The full faith and credit of the United States may appear to be on shaky ground, but that is mostly a reflection of the world’s view of our political leadership.

Growing Loss of Confidence in Leadership and Media

Polls show the low regard in which Americans currently hold our own elected officials. The latest Gallup survey poll taken during April shows that 48% of Americans have no confidence that the President will do the right thing for the economy. Only 38% have faith that the Republicans in Congress will do so, and only 34% have faith in Democratic Members of Congress. Even confidence in Jerome Powell has fallen from 43% last year to 36%. But those at the very bottom of the ranks are in the media. The latest AP-NORC poll finds that nearly three-quarter of U.S. adults say the news media is increasing political polarization. A Gallup-Knight Survey found that only 23% of respondents believed that journalists act in the public’s best interests; half say that national news organizations intend to mislead, misinform or persuade the public to adopt a particular point of view through their reporting. So much for the First Amendment.

What If

There are some in the media who posit that there are Members of Congress who are not moved by the prospect of default. The moment always provides rare leverage to those seeking major reforms and/or spending reductions. Traders warn of unthinkable long-term damage and recession akin to 2008. Over the years, the Federal Reserve as well as a number of academics and think tanks have explored the possible ramifications of a default. There is no clear consensus on all the impacts, many of which would involve legal challenges. The effects of such an unprecedented event on the financial markets alone are highly uncertain, but yields on Treasuries would likely rise noticeably, causing private rates to increase sharply and risk premiums to depress stock prices appreciably. Money market funds could experience extreme liquidity pressure. Dollar-denominated assets and the dollar itself could decline considerably and large sums of money could flow into other currencies or assets including gold. Much of course would hinge on how long the impasse is perceived to last, but the first-time event would change perceptions about the Treasury as the safest and most liquid security in the world and disrupt global markets. Investor fear of broader financial contagion. After all, global debt now exceeds a record $300 trillion according to a January estimate from S&P.

Impacts on the Municipal Bond Market

The delay in reaching an agreement on how to adjust the $31 trillion ceiling is already affecting the tax-exempt market. As part of the Treasury’s extraordinary measures that have been undertaken since we reached the debt limit in January, the State and Local Government Series Securities (SLGS) window, important to municipal borrowers refinancing bonds, was closed on May 2, the 16th such closure since 1995. But as rates have risen alongside the Fed’s target rate hikes during the last year, fewer refundings have proven economical, and so the market has not been widely impacted. But a failure to lift the debt ceiling or any delay in payments to those institutions dependent on federal funding could significantly harm nursing homes and hospitals dependent on Medicare and Medicaid reimbursements, public housing authorities and those receiving Section 8 payments, and many others. There is a possibility that investors shunning T-Bills might move into highly rated short-term munis. In addition, the Bank of America points out that historically long-term muni rates generally decline during the times in which the debt limit is being raised.

80 Million Stakes in a Swift Outcome

The good news is that Congressional and White House aides are at work on a resolution to this latest self-initiated crisis and the principals will meet again on Friday, their ears ringing with all the howling from Wall Street, Social Security recipients, military families and others. No elected official in Washington professes to want a default, knowing of the many potentially severe if not irreversible consequences. There is a House-passed bill to raise the limit by $1.5 trillion and cut spending on the table. On average, the Treasury makes 80 million payments every month, so there are at least 80 million people, businesses, agencies, and other institutions with a stake in a quick and positive outcome.

Other Market Movers This Week

Traders are closely watching the results of 8 Treasury auctions being conducted this week. There are 7 Federal Reserve officials on the speaking circuit. Investors are closely following key economic data scheduled for release, including the consumer and producer price indices, senior loan officer opinions on bank lending, consumer sentiment, and the latest monetary policy action being taken by the Bank of England. Futures traders are expecting a pause by the Federal Market Open Committee at its June 14 meeting. At this writing, the current target rate of 5.00% to 5.25% is expected to be cut by 25 basis points in September, again in November, December, and next January and February.

Municipal Market in Focus

Market technical improved for the tax-exempt sector last week but munis underperformed governments and corporates for the third week in a row. Taxable munis, long-dated munis and high yield munis are leading the way. Investors receive $20.6 billion of principal and interest on May 1 but only saw $7 billion of new issues as reinvestment options, so are scouring the secondary market for bonds with the highest yields and relatively low credit risk. The highest rated 1-year municipal general obligation bond benchmark yield at 2.97% is higher than the next 15 years of maturities, reflecting a yield curve that has been highly and most unusually inverted since last December. Traders are closely watching the auctions being held for some of the muni assets of Silicon Valley Bank. Market participants have largely lauded the recent acquisition of First Republic Bank and its $17 billion of muni assets, by JP Morgan Chase, after having been fearful of a fire sale of the high-rated, long-dated, low coupon bonds normally held to maturity in its portfolio.

HJ Sims in the Market with a Top-Rated Texas Charter School

This week’s municipal calendar includes a $14.1 million AAA rated issue of the Newark Higher Education Finance Corporation of Texas for Orenda Education, a multi-site school system with five campuses in Georgetown, Goldwaite, Belton and Kingsland educating 1,878 K-12 students, and featuring a current wait list of approximately 1,546. The deal is guaranteed by the Texas Permanent School Fund. Also on a calendar that may total as much as $8.7 billion are six other charter schools in Texas, California Colorado and Utah, and a $23.8 million non-rated note sale for Forefront Living San Antonio Bella Vida at La Cantera through the New Hope Cultural Education Facilities Finance Corporation. So far this year, taxable municipal bonds are returning 6.39%, non-rated munis are up 3.60%, BBB rated munis are +4.38%, and high yield corporates are +4.27%. U.S. Treasury indices are up 3.68%, while the S&P 500 is +8.31%. We encourage you to contact your HJ Sims representative for our latest market views and offerings as we enter a volatile period awaiting action from Washington that will bring us back from the brink. We offer no drama but present outcomes for income in times like these.

For more information on offerings or questions about current market conditions, please contact your HJ Sims representative.

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