Video: Debt Ceiling Dilemma – Rates, Inflation and Banks
Wednesday, May 10th, 2023
Episode 31 Cover

Stephen: With the looming issue of the debt ceiling, the Fed still on its path increasing interest rates and we just got a fresh reading on inflation this morning, plenty to talk about on this episode of the Smart Money Show.

Welcome back, and thanks for tuning in to another episode of the Smart Money Show. I’m your host, Stephen Rischall, and joining me today is my co-host Chris Carter. And we have a lot to talk about today, so let’s dive right in.

Chris: Absolutely Stephen. Our first topic today is to talk about what the Federal Reserve did last week. They increased its benchmark interest rate by 25 basis points, or 0.25%, bringing it to a range of five to five and a quarter percent which is the highest since 2007. And this rate increase was driven by inflation remaining above the Fed’s target even as economic growth is slowing.

The effects of the monetary policy are starting to become apparent however. We’ve all seen in the news what happened with the takeover of First Republic Bank, not to mention the Silicon Valley Bank and Signature Bank, several weeks ago that we talked about I believe, on our last episode. And although the market indicates that this could be the final hike in this cycle, Fed Chair Jerome Powell has not made a decision to pause quite yet.

Stephen: Exactly, Chris. Powell suggested that the current level of rates may be enough to bring down inflation. This was the fastest pace, the fastest, steepest hike to interest rates ever in history. We talked about that on some previous episodes. But look, I mean, lending standards, they’re gonna become more and more stringent. And this is gonna result in continued tightening and financial conditions are gonna get tight. There’s even an increased risk to recession, or as I like to call it, the the non-recession recession. We’ve been talking about that for the better part of the last year it seems like.

I’m curious to get your take on this, Chris. Lots of people on Wall Street are actually projecting that the Fed will actually cut rates later this year, and this is coming off the backs of the most recent increase last week. So what do you think? Are they gonna keep raising rates? Are they gonna cut rates? Are we gonna pause? What’s gonna happen?

Chris: Yeah, well, you know, because of the lag effect with these rate cuts, we were in the camp really for the past few months, that they should have paused a while back and they did not. That being said, I do think that they will pause now, and they’re gonna see how the data looks coming in over the next few months.

They’re gonna keep an eye obviously, on inflation, just make sure that is continuing to go down. They’re gonna carefully monitor the job market. It is interesting to note however, that the Fed has historically cut rates six to seven months after pausing. Which if we are right and they do pause after last meeting last week, that would mean based on history, rates would be cut towards the end of this year. But this doesn’t seem like that’s gonna happen this time around. Cuts do seem, in my opinion, in our opinion, more likely a 2024 story.

Stephen: Yeah, that’s a good point, Chris. I agree with you. I think the Fed should, and probably will pause with any changes to the Fed Funds rate through the rest of this year. We also just got the latest numbers on inflation. Actually this morning, they were released by the Bureau of Labor Statistics. For the month of April the Consumer Price Index increased 0.4%. Now that’s a fairly modest increase that’s in line with what we want to be seeing. You know, 0.1, 0.2, 0.3. Maybe 0.4 is a little bit on the high side. But look, this brings the 12 month CPI to 4.9%. That’s quite a bit lower, if you remember, if you watched this last year, some of the episodes, there was an episode we talked about the CPI, the 12 month trailing CPI was above 9%.

So, the monthly level of inflation really has come down quite a bit at this point. Moving on to our next topic, the debt ceiling. You know, we’ve been getting lots of calls and questions about this one. And it’s potentially one of the most contentious debt ceiling showdowns ever in history. And I know we’re talking about a ceiling here, Chris, but we’re all just banging our heads against the wall, right?

Chris: Yeah, I mean we’ve all seen this movie before. Some of us who’ve been in the business or have been invested for a while have seen it more than others. But you know, that’s right. The Republicans control the House of Representatives, while Democrats are in command of the Senate. The Democrats have said they won’t negotiate on the issue, while many Republicans have said they won’t vote to lift the debt limit without some additional agreements to curb spending.

Now if the US does wind up in a technical default on its many debt obligations, including payments to bond holders, it could jeopardize the US dollar status as the world’s reserve currency. However, the probability of an even a technical default or a delayed payment, it is low, but it is not zero.

Stephen: Yeah, you know, it’s a valid concern. If the US missed a payment on a short term note due in June, that would probably spark an outcry in the markets accompanied by some amount of volatility, but probably for a short period of time. And then it would seem that by then the debt ceiling impasse would likely come to an end. This is essentially what happened back in 2011.

Chris: Yeah, that’s spot on. What happened in 2011 is very similar in many ways to what’s happening today. The fallout, of course, was that the market took a hit. Many of you probably remember that. Lots of volatility for about a week. But then the markets did recover fairly quickly. One more thing that happened back in 2011, Stephen, is the S&P actually downgraded the credit rating of the US government from AAA to AA+, where it still remains today.

But from an equity, from a stock investor’s point of view, the the debt ceiling debate makes for interesting political theater, but it’s not something that weighs too heavily on investment decisions. But at the same time, it’s essential to engage in a serious discussion about long-term fiscal responsibility.

Stephen: Absolutely, Chris. And finally, let’s talk about recent bank failures and the pressure that still seems to remain on some regional US bank stocks. You know, many banks have seen large declines in their stock prices this year, and the volatility has remained elevated following the failures of Silicone Valley Bank, Signature Bank, and most recently, First Republic Bank.

Chris: Yeah, the root cause of these banking challenges is really a byproduct of the pandemic. The really unprecedented government stimulus and increased savings rates caused bank deposits to really balloon during the pandemic, providing a low cost source of funding really.

Stephen: Right, and the banks, they invested these deposits and securities such as bonds, with higher yields than those paid on deposits normally. Right, and in order to earn the difference between these yields, and that was, you know, on top of that we were talking about how Covid, and some of the supply chain issues and the demand for goods, you combine all those things with labor shortages, inflation, and all the stuff that we had talked about in ad nauseam last year, and that’s really what led to a lot of the pressure on these banks.

Chris: That’s right. And to cool inflation, the Fed raised interest rates at a faster pace than any time in history, from basically zero to, as I mentioned earlier, five to five and a quarter percent. So as a result, the trillions of dollars that are in the US Treasuries and other short-term bonds held at these banks have decreased in value. So again, interest rates and bond prices have an inverse relationship. Interest rates go up, and as fast as they went up last year, those prices, of especially the longer duration treasuries, go down.

But if the banks, you know, if they were able to hold those treasuries until maturity, they would get the full amount they paid for them back plus the interest that they were planning on getting. But if banks are forced to fire sale these bonds at a loss because a large portion of the depositors are showing up to ask for their money, this puts a major, major stress on the bank and is a huge reason why we’ve seen some of these banks fail recently.

Stephen: Yeah, that’s a great summary, Chris. While there may still be some drama to come for other small regional banks, I think it’s important to point out that all customers of these three banks we mentioned earlier have had all of their deposits made available to them again.

Chris: Yeah, one final note about these banks, Stephen. I’m not aware of any bank customers that actually lost money. Frankly, the FDIC has done a tremendous job taking over and transitioning these banks so that customers can continue to access their money. And our view is that most of these banking issues are isolated to very specific types of banks with very specific customers. And while there may still be some fallout that we see, it doesn’t seem to be an issue that will spiral outta control.

Stephen: Yeah. Thanks, Chris. That’s all the time that we have today, folks. Thank you for watching. And if you know someone that might benefit from learning about this too, please send them this video. Until next time, I’m Stephen. That’s Chris. And this is the Smart Money Show.