US Shutdown Ends (For Now), Debt Ceiling Battle Up Next

The US government has reopened after the partial shutdown that lasted 35 days. Yet the clock is running since the stopgap spending bill only funds the government through February 15. Even if a lasting deal is reached, this recent dysfunction suggests problems ahead as the debt ceiling comes back into effect March 2.

RECENT DEVELOPMENTS

Democrats and Republicans will meet this week to begin the difficult task of reaching a compromise to keep the government open before February 15. We believe Republican Senators will not want to close the government again. Six crossed over and voted for the Democratic bill last Friday, and we suspect more will defect if faced with the prospects of another shutdown. Indeed, reports suggest that many Republican Senators voiced their opposition to another shutdown at the Republican luncheon last Thursday.

On the other hand, Democrats have signaled that they are willing to offer more money for border security but not for a wall. Both parties have expressed support for a package that includes money for new technologies to detect drugs and weapons, more border personnel, more immigration judges, and improvements to infrastructure at ports of entry. It may boil down to a matter of semantics in which both sides can claim victory.

Meanwhile, President Trump is threatening to call a state of emergency if the compromise does not include funding for the wall. Press reports suggest that Trump wanted to declare the emergency Friday alongside his announcement that the government would reopen. However, reports add that Senate Majority leader McConnell opposed this and was able to quash the idea.

The Congressional Budget Office (CBO) estimates that the shutdown cost the US economy $11 bln. That $11 bln loss was split up as $3 bln in Q4 and $8 bln in Q1. However, the CBO sees $8 bln of that total being made up as back pay is given to federal workers. In terms of growth, the White House Council of Economic Advisers (CEA) last estimated that each week of closure shaved off 0.13 percentage points from quarterly growth. The CBO also sees faster growth over the next two quarters as the economy plays catchup, and forecasts 2.3% growth for the whole year.

Even if the two sides can reach a deal to keep the government open past February 15, they must next deal with the debt ceiling. The ceiling was suspended last February after a brief shutdown lasting three days. It was basically another can-kicking exercise, as the ceiling comes back into effect March 2.

 

A BRIEF HISTORY LESSON

How did the debt ceiling come about in the US? In the early days of the union, Congress typically issued debt for specific purposes. For instance, to build the Panama Canal or to fund the Spanish-American War. As World War I developed into an open-ended conflict, Congress decided it was simply easier to establish a general limit on borrowing. It did so with the First Liberty Loan Act of 1917, which established a $5 bln limit on new bond issuance as well as the immediate issuance of $2 bln in one-year certificates of indebtedness (later replaced by T-bills).

As the costs of WWI grew, it was necessary for Congress to pass the Second Liberty Bond Act of 1917. That increased the limits to $9.5 bln for Treasury bonds and $4 bln for 1-year certificates of indebtedness. By the end of WWI in November 1918, the total limit had been raised to $43 bln, which compared to the $25 bln of outstanding public debt in 1919.

After WWI, all increases to the national debt were made as amendments to the Second Liberty Bond Act. In 1939, Congress created an overall aggregate limit on the national debt rather than on various maturities and the debt ceiling as we know it was born. In principle, the ceiling was meant to make life easier for Congress. Indeed, for the first 10-15 years, it was raised without controversy or incident.

Instead, it has become a political sledgehammer. The first debt ceiling fight began in 1953, when President Eisenhower faced a revolt by the Republican-controlled Senate. Eisenhower wanted more funding to build the national highway system, but Congress had become alarmed at the buildup in the national debt during WWII. After much wrangling and some emergency measures taken by Treasury, the debt ceiling was raised in 1954. It turns out that the ceiling has very little real meaning, having been raised more than 80 times since 1959.

 

ECONOMIC OUTLOOK

The economic costs of the shutdown are not insignificant. This month, the head of Trump’s Council of Economic Advisors Kevin Hassett estimated that the shutdown reduces quarterly GDP growth by 0.13 percentage points for every week that it lasts. This is greater than initial CEA estimates of 0.1 percentage points for every two weeks that it lasts.

Hassett later warned that zero growth was possible in Q1 if the shutdown dragged on, but that seems too pessimistic now. He also said that the odds of a recession in 2020 were “very very low.” This seems too optimistic, as we think most agree that the odds of recession next year were high even before the shutdown.

Another solid US jobs report is expected this Friday. It’s worth noting that the weekly initial jobless claims number for the survey week (the one that includes the 12th of the month) fell to 213k. Claims then fell the next week to 199k, the lowest since 1969. According to guidance from the BLS, federal employees who are furloughed will be counted as employed. Furthermore, those who are working but not receiving pay will also be counted as employed. Bottom line: the shutdown’s impact on the jobs data should be limited.

It will take the Commerce Department quite some time to catch up with all the delayed data. These include (but are not limited to) trade, inventories, retail sales, and personal income and spending. Q4 advance GDP was due out this Wednesday but has been delayed due to the lack of data collection during the shutdown. Bloomberg consensus sees 2.6% SAAR growth, down from 3.4% in Q3. The Atlanta Fed’s GDPNow model is currently tracking 2.7% SAAR growth for Q4, down from 2.8% previously. The New York Fed’s Nowcast has Q4 growth at 2.6% and Q1 at 2.2%.

The IMF recently revised down its global growth outlook to 3.5% for this year. However, this was due largely to the eurozone, where the 2019 growth forecast was cut from 1.9% to 1.6%. More specifically, Germany (cut from 1.9% to 1.3%) and Italy (cut from 1.0% to 0.6%) were the biggest drags on the overall eurozone. The IMF’s US forecast was kept unchanged at 2.5% for 2019.

 

RATINGS OUTLOOK

Back in October, we wrote that the US had improved modestly and moved back (barely) into AAA territory. It has been going back and forth between AAA and AA+ for several quarters and bears watching. In other words, the US was already skating on thin ice with the rating agencies. The shutdown highlights just how dysfunctional things are in Washington now, and that bodes ill for the upcoming debt ceiling debate.

S&P was the first and only agency to downgrade the US. This was back in 2011, when a bruising fight over the debt ceiling highlighted another period of political dysfunction. S&P cut the US rating to AA+. The other two agencies moved their US rating outlooks to negative during this period but did not pull the trigger on a downgrade like S&P did.

Recently, Fitch issued a timely warning of a possible cut to the AAA rating for the US. The agency said that if the shutdown continues to March 1 and the debt ceiling becomes a problem a couple months later, it may need to consider whether the policy framework and the inability to pass a budget are consistent with a AAA rating for the US.

Moody’s also weighed in, saying recently that their base case is that Congress and the White House come to an agreement before the debt ceiling becomes an issue. If so, Moody’s said its Aaa rating would remain intact. Yet, if this doesn’t prove to be the case and there is a technical default, Moody’s acknowledged that a downgrade would then become more likely.

 

INVESTMENT OUTLOOK

We continue to believe that the US rates markets need to adjust higher. The economic uncertainty generated by the shutdown will take some time to clear up, but we remain upbeat on the US economic outlook this year. We believe the Fed will hike twice this year, but this is predicated on a no-recession scenario.

US rates are also likely to move higher this year just on the unprecedented supply that’s in the pipeline. We will know more after tomorrow’s quarterly refunding announcement. The FY2018 budget deficit widened to-3.8% of GDP despite robust growth. The Congressional Budget Office (CBO) estimates that the budget deficit will widen to -4.6% of GDP in both FY2019 and 2020 and then to -4.9% in FY2021. Past US experiences suggest the deficit could widen to -8% of GDP in FY2021 if there is a protracted recession that begins next year.

If our rates forecast materializes, it would be dollar-positive. Even as risks to the US build, things have gotten even worse elsewhere. Markets are becoming increasingly doubtful of the ECB’s ability to lift rates this year. The BOJ recently cut its inflation forecasts, suggesting stimulus will be maintained until at least FY2021. Global growth continues to slow, which would weigh on EM disproportionately.

The US equity outlook is a bit harder to pin down. Still-robust growth would tend to support equities, but then the resulting specter of tighter Fed policy would tend to weigh on them. From a relative standpoint, however, we are confident the US equities would outperform within DM.