09.28.2023 As we enter what we hope will be the final stage of the Fed’s monetary tightening program, multiple economic and market challenges face the Federal Open Market Committee, investors, households, and leaders in Washington DC. These challenges run the gamut from high oil prices to the threat of a government shutdown. Consumer confidence is weakening and the Biden administration’s economic approval rating is tanking. What could lie ahead?
The price of a barrel of crude has spiked to over $90/bbl, up from $70/bbl as recently as July. The move coincided with simultaneous production cutbacks by Saudi Arabia and Russia amounting to nearly one million barrels/day. Prices at the gas pump spurted in sympathy: the average price of regular unleaded is $3.82/gallon, up from $3.52/gallon on Independence Day. At the same time, our Strategic Petroleum Reserve (SPR) has been depleted since the last time President Biden opened its valves last year.
Adding to economic woes are the writers, actors, and autoworkers strikes. It appears that the 148-day Writers Guild of America walkout could be nearing a conclusion. However, the more than 4,000 days of idleness due to work stoppages as of the end of August dwarfed all strike activity over the last decade. This suggests labor costs will rise and, in today’s tight market, margins could compress at a time when earnings among S&P 500 companies are expected to be flat for the year.
Meanwhile, if Congress doesn’t pass a continuing resolution over the next few days the government will be forced to shut down. While policymakers attempt to negotiate a higher debt ceiling, few in Washington are focused on our immediate budget challenges. The Treasury faces $2.6 trillion in bond maturities next year with existing bonds carrying a two percent coupon, on average. That suggests interest expenses, as part of the federal budget, will likely increase by about $100 billion annually as those maturing bonds are rolled over and new bonds are issued. Current trends indicate interest expense will surpass defense spending to become the largest discretionary spending item by the end of 2025.
Another factor upsetting the equity apple cart is higher Treasury rates. The benchmark 10-year Treasury yield has been climbing steadily since the summer, pushing the yield to over 4.5 per cent, its highest reading since 2007, long before the Fed embarked on its quantitative easing program. The move was fueled by rising real rates, the 10-year Treasury yield relative to inflation expectations. Perhaps bond investors are beginning to impose a “distrust premium” on the federal government. The impending government shutdown, underscoring rating agency Fitch’s concern that fiscal intransigence poses a credit risk to our nation’s debt worthy of a downgrade. Unfortunately, higher real rates filter through to all borrowers, increasing the cost of financing businesses, housing and automobiles, among other things.
Bottom Line: For the most part, higher energy and interest costs are helping do the Fed’s work for it, suggesting that rising energy and interest costs will serve as a tax, funneling resources away from discretionary spending. The recent deterioration in consumer confidence exemplifies that trend. That also mirrors a significant decline in President Biden’s approval rating. According to a recent ABC News/Washington Post poll, only 30 per cent of those surveyed approve of his job on the economy, with 64 per cent disapproving. While the Fed’s game plan may be cloudy as monetary policymakers weigh the second-order impacts of recent trends, President Biden’s game plan should be clear: he needs to offer leadership on the federal budget and spending before the bond market does.