What investors should know as U.S. debt-ceiling negotiations continue

Executive summary:

  • U.S. lawmakers express optimism over potential debt ceiling deal
  • Fed meeting minutes show diverging views on rates
  • New PMIs point to growth in services, decline in manufacturing

On the latest edition of Market Week in Review, Director of Investment Strategies, Shailesh Kshatriya, discussed the latest developments in the U.S. debt ceiling negotiations and the minutes from the U.S. Federal Reserve (Fed)'s May policy meeting. He also reviewed recently released purchasing managers' index (PMI) surveys from around the globe.

Debt ceiling talks continue in Washington, D.C., as deadline looms

Kshatriya started by providing an update on the status of talks between lawmakers in Washington, D.C., over increasing the nation's borrowing limit, or debt ceiling. He noted that U.S. President Joe Biden and Republican House Speaker Kevin McCarthy met during the week of 22 May, but had yet to arrive at a deal as of market close on 25 May. "However, both Republican and Democratic lawmakers continue to express optimism, and the latest news reports indicate the divide between the two sides is narrowing," Kshatriya stated.

He explained that the sticky issue in the negotiations centres around spending, with the Republican Party believing that excessive spending is partly responsible for high inflation. As a result, Republicans in the U.S. Congress are demanding fiscal discipline via substantive spending cuts, Kshatriya said. This is at odds with the Democrats, who believe that the spending is targeted toward initiatives that will benefit growth prospects, he noted.

Amid the ongoing discussions, on 21 May, U.S. Treasury Secretary Janet Yellen once again warned that the Treasury Department would "almost certainly" run out of funds to meet its obligations by early June, Kshatriya stated. In addition, he said that on 24 May, Fitch one of the leading credit-rating agencies placed the U.S.' sovereign AAA credit rating on a "negative" watch due to the political stalemate.

"This is similar to what occurred in August of 2011, when Standard & Poor's initially placed U.S. debt on a negative watch, but eventually downgraded it to AA+ from AAA , despite a last-minute resolution among lawmakers to avoid a default. Today, the U.S. economy is again caught up in a dangerous game of chicken being played by policymakers," Kshatriya observed.

He stressed that if there is no deal by the end of the holiday weekend in the U.S., the odds that the so-called X-date could be breached would rise. Kshatriya noted that in prior debt ceiling scares, the Treasury Department has indicated it plans to prioritise principal and interest payments to avoid a technical default.

"The longer the Treasury is forced to prioritise these payments, the larger the fiscal contraction would be. This is because the department's other obligations including payments to social security recipients, military personnel and government contractors are among the items that could be delayed," Kshatriya said, explaining that these other obligations comprise roughly 7% of the country's GDP (gross domestic product).

Not only would skipping these payments bring forward recession risks to the U.S. economy, but just as significantly, it would also damage the credibility of policymakers, he noted. "The key takeaway here is that while the Treasury has a backup plan, it's no substitute for making a deal before the X-date," Kshatriya concluded.

Highlights from the Fed's May meeting minutes

Turning to the Fed and its year-long fight to tame inflation, Kshatriya said that the release of minutes from the Federal Open Market Committee (FOMC)'s meeting earlier this month reveals a committee divided on whether to pause or hike rates in June.

The minutes show that several members are inclined to assess the effects of prior hikes on the economy, and therefore are leaning toward a pause, he noted. Others, meanwhile, believe that with the U.S. labour market remaining tight and inflation still well above target, additional hikes are warranted, Kshatriya said.

"Market pricing has shifted toward the latter view, with investors putting the odds of a rate increase at the Fed's 13-14 June meeting at roughly 50-50. However, Fed Chair Jerome Powell may be leaning toward a pause ," he noted. Kshatriya explained that at a recent speech, Powell indicated that tighter lending conditions triggered by regional bank stresses will do some of the work for the Fed, meaning that the central bank may need to raise rates less than previously thought.

"At Russell Investments, we're in line with the chairman's thinking and we also believe that his words carry more weight. Because of this, we think a pause in rate hikes is likely in June," Kshatriya stated. He added what the minutes also show is that the Fed is no longer on a predetermined course when it comes to rate increases. In other words, going forward, decisions on rates will likely be determined by incoming data, Kshatriya said.

Flash PMIs suggest growth in services sector, decline in manufacturing sector

Kshatriya finished off by peering into the latest round of preliminary or flash global PMI readings released by S&P. In a nutshell, the surveys show that a bifurcation of growth in the global economy between the services and goods sectors is continuing, he stated.

"On one hand, the manufacturing PMIs a survey-based measure of the strength of the manufacturing sector and a forward indicator for goods demand sit below the boom-bust level of 50 for the U.S., eurozone and the UK. On the other hand, the non-manufacturing PMIs a forward proxy for services-sector demand remain above 50 for all three regions," Kshatriya stated, explaining that a reading above 50 indicates expansionary conditions, while a reading below 50 points to contractionary conditions.

He added that the one notable exception to this was Japan, which saw both its manufacturing and non-manufacturing PMIs improve.

Overall, the strength in the services economy is one reason why global growth trends have come in better than expected, Kshatriya said. However, he stressed that the broad weakness in manufacturing cannot be ignored. "Most forward-looking components within the surveys, such as manufacturing new orders, are contracting in several regions, suggesting weak demand," he stated. Kshatriya noted that in the U.S., a manufacturing contraction alone doesn't make a recession imminent, as the nation's economy is roughly 85% services-based. On the other hand, this decline could be more widely felt in Europe, he said, given that the region is more exposed to manufacturing.

"Coincidently, first-quarter GDP in Germany was recently revised lower to -0.3%, versus a flat reading initially. This means the German economy entered a technical recession, with back-to-back quarterly declines in GDP," Kshatriya said. Ultimately, because Germany is the largest economy in the eurozone, its struggles tend to influence the entire region, he concluded.


Any opinion expressed is that of Russell Investments, is not a statement of fact, is subject to change and does not constitute investment advice.