Three Key Crises Affecting the United States - ING

There is a common thread among the three crises currently felt in the United States. The inflation crisis was triggered by a politically toxic pandemic. The looming debt ceiling crisis stems from political activity that has worsened more than ever before. The third crisis is the banking crisis, partially due to the Fed's response to the inflation crisis. Where are we now？

Outside Ebbing, Missouri, there are three billboards that say, “We have a big problem to solve.” Their development has been slow but steady. The next few months will be a critical period of success or failure.

• During the pandemic, we planted the seeds of inflation as power was passed from Trump to Biden, and the resulting prosperity encountered a lack of access to goods. The inflation crisis was able to take hold.

• The pandemic itself did not quell the extreme political heat that had formed around Trump before and after, and in fact, it only became more intense. As a result, the debt ceiling crisis is looming.

• Then, from zero interest rates to 5%, and from massive liquidity injections to withdrawals, there is always the potential for a reaction somewhere. The banking crisis is not entirely attributable to this, but it is clearly not unrelated. The inflation crisis contributed to this.

Looking ahead, what we least need right now is political and stubborn debt ceiling threats posing a substantial threat to the system. So, what is the future market discount？ Mixed – we assess.

The development of the banking crisis, measured by the regional bank index and FRA/OIS, presents significant risks but may be bearable.

We can track some indicators to help assess where we are and where we might be heading. Let's start with the banking story, particularly the pressure on small and regional banks on deposits. The US regional bank index tracks market sentiment. A few months ago, it was at 120. Now it's at 80. Looking back, the pandemic brought that number down to 60. Before that, the Great Financial Crisis took the index down to 40. This is a potential plunge of doom from 80 to 40. The question is, will it happen？

So far, the answer is likely no. We will take the 3rd month FRA/OIS spread as a guide. It essentially measures the premium banks implicitly need to pay relative to the risk-free rate in the forward space. Currently, the 3rd month FRA/OIS spread is around 40 basis points. It skyrocketed to 60 basis points when Silicon Valley Bank collapsed. After returning to a low point in the 20s, the climax of the First Republic story pushed it up again. When the financial crisis broke out about 15 years ago, the FRA/OIS spread quickly rose to 70 basis points, and then fell to over 150 basis points.

We are still far from that. A neutral simple reference is 20 basis points. We are already twice that, which is troublesome, but does not rule out a system collapse or something similar.

Using breakeven inflation rates to gauge the inflation crisis resolution – somewhat optimistic

The pressure on banks to a certain extent reflects the Federal Reserve's policy stance shift towards tightening in response to mounting inflation concerns. While these concerns have eased somewhat, they have not disappeared – the latest core personal consumption expenditures (PCE) data still pegs the US as a “5% inflation” economy. But there is some good news from the market breakeven inflation rates, which are derived from the difference between traditional Treasury yields and the real yields of inflation-hedging securities. These inflation breakevens not only have a handle on 2% on the curve, but are closer to the big 2% number, rather than 3%.

The breakeven inflation rate at a low level of 2% – if achieved, things will calm down

In fact, the two-year breakeven inflation rate just fell below 2% this week. If this is the final outcome, then the Fed's job of hiking rates is done, and it does indeed lay the groundwork for future rate cuts. Though rate cuts may come simultaneously with rising consumer and corporate default rates, and there is a feedback loop in which the pressure on the banking system is closely watched, particularly in the commercial real estate industry. If these inflation expectations fail to materialize, the situation will become more severe, making it harder for the Fed to implement easing measures as a buffer.

The Debt Ceiling Crisis Measured by US Sovereign Credit Default Swaps - Concerning, but Solvable

As we move forward down this path, we face a dilemma with the debt ceiling, which is intertwined with political threats and carries the risk of default. Missing just one interest payment would mean default. The market is highly concerned about this, with 5-year credit default swaps (CDS) currently around 75 basis points. This is the highest level since the Great Financial Crisis and the highest ever for core eurozone countries. While there is no cross-default risk for US Treasuries (i.e. one defaulting bond dragging others into default), even just missing one interest payment would inflict significant damage on US Treasury products.

One bond default may not be catastrophic, but it could be.

Many participants are unwilling to take on the risk of a bond default appearing on their books, and the collateral value of US Treasuries will be under strict scrutiny. If the debt ceiling issue is resolved quickly and holders are immediately compensated, one default should not destroy the entire system. However, things could quickly spiral out of control. Essentially, the entire global financial system is threatened. Note that although US CDS prices have indeed risen, they are still far from discounting an actual default - they are merely betting on a (slight) possibility of it.

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