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Stealth Tightening

Not surprisingly, an agreement appears to have been reached to raise the debt ceiling. While negotiations were fraught, the debt ceiling has been raised nearly 80 times since 1960. That might explain the relatively muted market impact (so far). Indeed, it appears that the market might have already begun to trade off the prospects of significant new issuance and trying to decide how much of a rates impact this will have.

The forward-looking point is that there is likely to be a sharp increase in Treasury issuance. The Treasury General Account will have to normalise which in turn will lead to a contraction in the Fed balance sheet. Hence, we could see central bank balance sheets shrink more sharply and this might contribute to another challenging phase for equity performance (chart 1).

As we have noted previously, the importance of liquidity in this cycle has been the connection with aggressive fiscal policy following the pandemic. The liquidity was not simply held has bank reserves but contributed to a genuine multiplier through the real economy. Looking forward, renewed fiscal consolidation (or tightening) would likely be a drag on growth.

From a currency perspective, in theory there could be a positive US dollar impact if non-US investors are attracted to rising US yields now that credit risk is (largely) done. However, foreigners might demand an additional premium to add US dollars to their US holdings. Tactically, this would normally lead to a small “risk-on” or US dollar negative impact in the short term.

Although with US equities already firm, Fed hawkishness reasserting itself and macro conditions abroad deteriorating, it might be a US dollar positive development near term. Either the US data must soften, or non-US macro conditions need to improve to bring us back to the soft part of the US dollar smile. The challenge for the rest of the world is that the US dollar remains a positive carry haven currency. Near term resilience also increases the likely US terminal rate and policy reaching genuinely restrictive levels. Our sense is that the odds of a hard landing remain uncomfortably high even if the timing is much later than the prevailing bias.


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