US vulnerable to credit crunch despite debt ceiling deal

By the OFX team | 8 Jun 2023 | 5 minute read

Currency markets have relaxed now the agreement to suspend the US debt ceiling until January 2025 has passed the House of Representatives and Senate. Had the bill not gone through, the US government faced defaulting on its financial commitments by June 5.

Total US government debt is $US31.4 trillion, and if the deal had not passed, the government wouldn’t have been able to pay for essential services like public sector salaries, Medicare, the Military Social Security and more.

The legislation was signed with just two days to spare until the Treasury Department warned the country would start running short of cash, which would have sent shock waves through the US and global economies.¹.

Rating agencies were getting nervous about US debt levels. Fitch Ratings threatened to downgrade the U.S. credit rating, citing concerns over the protracted debate. Other major ratings agencies haven’t followed suit, but as the US heads toward a likely divisive election next year, could see this debt issue raise its head again. If agencies worry about a political impasse, that could influence how bonds are priced, pushing up borrowing costs at a time when the US has already raised rates 11 times in a year.

Rising rates and the risk of corporate defaults

The US government is not the only entity worried about paying its interest bills. American businesses are also at risk². Such a rapid rise in interest rates is changing the calculus for many firms that’ve been dining out on cheap debt for years. And as markets become increasingly nervous about debt, there could be rises to interest rates on the debt, over and above the Federal Reserve’s cash rate.

By the end of last year, debt held by US businesses amounted to a record $20 trillion, not far off the Federal debt of $27 trillion.³

Distressed debt — typically bonds or loans that are trading at significant discounts to their face value due to the increased risk associated with the borrower’s financial position — is on the rise, and at levels rarely seen in the past decade.⁴ And banks are getting nervous. 

Last week, the US Federal Reserve released its results for the quarterly Senior Loan Officer Opinion Survey which shows that nearly half of US banks plan to raise their lending standards due to concerns about loan losses.⁵ The collapse of mid-tier US banks has made risk aversion more acute, given the danger of a run on deposits (as seen with Silicon Valley Bank and others) could render them insolvent.

This means that some firms may struggle to refinance at all, while others may face much higher borrowing costs that they may be unable to meet.

“You can expect that as a consequence, companies who have to refinance over time are facing debt servicing where interest bills are three or four times higher and some of them will not make it. That’s the environment over the next 6-12 months,” Beat Wittmann, partner at Porta Advisors told CNBC.⁶

Furthermore, it leaves the US vulnerable to a credit crunch, or, as the Federal Reserve revealed following its May meeting; “Tighter credit conditions for households and businesses are likely to weigh on economic activity, hiring, and inflation⁷.”

Between a rock and a hard place

You would think that all these signs point to a slowing US economy, meaning the US Federal Reserve can hold off on any more rate rises, but consumers haven’t been playing ball. Data released on May 26 shows that consumer spending rose 0.8% between March and April. That is equivalent to almost 10% growth in consumer spending annualised and would be highly inflationary.

“Right now, when I look at the data and when I look at what’s happening with the inflation numbers, I do think we are going to have to tighten a bit more,” Federal Reserve Bank of Cleveland President, Loretta Mester, told CNBC.⁸

Interest rate rises generally have a lagged effect, but the Federal Reserve would have been hoping that a year of monthly interest rate rises would have quashed demand to help reduce inflationary pressure. It’s not just the rises themselves, but the messaging around them that was supposed to work.

Instead, the Fed may have to raise rates again at a time when liquidity is already drying up and funding to businesses is being cut.

The danger is that this latest round of rate rises may compound the downward pressure on the economy that is due to hit in the coming months.

That means the chance of a hard landing is getting higher.

What that means for currencies

Counter-intuitively, a US recession may actually result in the US dollar rising. During times of economic uncertainty, the US dollar often benefits because of its status as a global safe-haven currency that attracts investors seeking a safe place to park their funds. It may compound a potential slowdown in other countries and regions as US consumption declines, weakening their currencies in turn.

If that hard landing looks more likely, the Federal Reserve may need to look at cutting rates, making employment, consumer spending and inflation figures a must-watch for the rest of the year.

If they start to turn sharply downward, the US dollar should start to ease.

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