NY Fed President Bill Dudley Retiring

The Federal Reserve"s "smooth transition" from Janet Yellen to Jay Powell is set for a major speedbump.

Just two short days after Donald Trump confirmed what weekly trial balloons had reported for weeks, namely that Janet Yellen is being replaced with most "dovish" alternative possible in the face of former Carlyle partner and 5 year Fed governor Jerome Powell, the person who according to some is even more instrumental to Fed policy than Janet Yellen, NY Fed president Bill Dudley is reportedly leaving.

Late on Saturday evening, CNBC"s Steve Liesman reported that Fed vice chairman Bill Dudley, a former Goldman managing director and chief economist, not to mention a key figure in "the unprecedented government response to the financial crisis", is set to join Janet Yellen among the ranks of the unemployed (if only until he hits the speaking circuit and writes a book explaining that the Fed is the cause of the world"s problems) and announce his retirement as soon as next week. 

Dudley, who has has headed the bank since 2009, will likely retire sometime in the spring or summer of 2018 when his replacement is found and approved, sources told CNBC. His term ends in January 2019. A search committee has already been formed.

According to Liesman, Dudley told several colleagues he was planning to leave in 2018, "and his departure is said not to be related to the decision last week by President Donald Trump to name Fed Governor Jerome Powell as the next Fed Chairman." Which probably means that Dudley"s departure is precisely that: a protest against Trump"s removal of Yellen with whom Dudley had a pristine relationship.

Dudley, set to turn 65 next year, became NY Fed president in the immediate aftermath of the Great Financial Crisis and was instrumental in devising the Fed"s ZIRP and QE policies.

As president of the New York Fed, Dudley holds a special spot among the dozen regional bank presidents. The incumbent always serves as vice chairman of the rate-setting Federal Open Market Committee (FOMC) and always votes at policy meetings, while other regional presidents have a rotating vote. More importantly, before he became NY Fed president, Dudley headed the New York Fed"s markets group - also known elsewhere as "the plunge protection team" - which Liesman describes as "a critical job that oversees the trades and market operations required to set the Federal Funds Rate." Liesman is right.

In both positions, Dudley was a principal player in Fed decisions concerning the demise of Lehman Brothers, AIG and Bear Stearns, along with emergency measures taken by the central bank to stanch a meltdown in the financial system.

Dudley"s "list of accomplishments" is long: several trillion dollars long in fact. Under the former Goldman executive, the NY Fed was responsible for accumulating the trillions in assets the Fed purchased under QE, bringing its balance sheet up to $4.5 trillion. It is now responsible for the market operations underway to reduce the balance sheet.

Dudley"s departure comes at a time of dramatic change at the Fed. in addition to a new Fed Chairman, Vice Chairman Stan Fischer left his post in October, and there are currently three open seats on the seven-member Board of Governors. That number may rise to four if Yellen leaves the board when Powell is confirmed, and before others are nominated and confirmed by the Senate.

The choice of Dudley"s replacement will be made by the New York Fed"s Board of Directors and approved by the Federal Reserve Board. Dudley is expected to speak at the economic club of new York at noon on monday.

With Dudley"s departure, the Fed will lose one of its more prominent centrists as the following Dove-Hawk ranking from Barclays shows.

As for new Fed chair Jay Powell, while many already had a low opinion of him being able to keep the system together once the next crash happens, the departure of a key Fed veteran such as Bill Dudley will only make it that much more complicated to preserve stability in the not too distant future. Here are some scathing thoughts from Capital Economics on Powell"s tenure as next Fed chair:

Powell an underwhelming choice to be Fed Chair

• Some are born great, some achieve greatness and some have greatness thrust upon them. Jerome Powell belongs in the third category. President Donald Trump’s nomination of Powell to be the next Fed Chair is an underwhelming choice. The Fed will face many difficult challenges over the next few years and it is unclear whether Powell has the skills to navigate them.


• The polite thing to do would be to offer some platitudes about Powell being the ‘safe’ choice, who will provide continuity with the Yellen-led Fed’s monetary policy approach of gradually normalising interest rates and might be more inclined to loosen financial regulation. That said, although Powell is more open to deregulation than Yellen, he is hardly a free market zealot. He has expressed support for simplifying and “recalibrating” regulation, particularly the Volcker rule but, at the same time, he has warned that “it is essential that we protect the core elements of these reforms for our most systemic firms in capital and liquidity, stress testing and resolution”. At least financial markets will be comforted that Trump didn’t pick the potentially much more hawkish John Taylor or Kevin Warsh.


• Nevertheless, Powell’s resume is not up to the standards we would expect of a nominee for Fed Chair. For a start, unlike the last three Fed Chairs, he is a lawyer rather than an academically trained economist. His other experience is in investment banking and private equity. He also spent some time at the Bipartisan Policy Center and worked in the Treasury for a couple of years during the Bush Snr administration. None of those roles marked him out to be the next leader of the world’s most important central bank.


• Powell was only nominated to join the Fed’s Board of Governors in 2011 because then-President Barack Obama needed a token Republican to ease the accompanying nomination of Jeremy Stein through the Republican-controlled Senate. Since joining the Board, Powell has had little to say of any interest. His speeches have focused on regulatory issues and when he has spoken about monetary policy issues, he has been careful never to deviate from the in-house view. Not surprisingly, markets initially didn’t see Powell as a possible candidate to be Fed Chair.


• Admittedly, we could be wrong about Powell. He is still something of an enigma and he may emerge as a strong leader with a firm grasp of monetary and economic issues. His Senate nomination hearing in the coming months will provide the first insight into what type of Fed Chair he will be. Regardless of his performance at the hearing, however, we expect him to be confirmed without too much drama.


• There is an argument to be made that Powell’s market experience could prove to be crucial in the coming years. But there are potentially even bigger challenges ahead. As an institution, the Fed is grappling with the most fundamental question of what drives inflation in the modern US economy, as it seeks to explain why it has been unable to hit its 2% inflation target consistently. Should the Fed stick with the orthodox Phillips curve view that shrinking slack in the labour market and wider economy will eventually generate an acceleration in wage and price growth or abandon that framework? If the Fed does abandon it, what becomes the working model of inflation? Inflation expectations? Does inflation targeting even make any sense in a world where interest rates influence domestic activity and employment, but activity and employment don’t influence prices? Monetary targeting was abandoned because the old relationships with prices broke down. Inflation targeting isn’t sacrosanct. We would feel more comfortable if it was the academically outstanding economist Janet Yellen who was leading that research, particularly when she had the benefit of the strong intellect and experience of Vice Chair Stanley Fischer at her side.


• Powell’s nomination means that we still expect the Fed to raise interest rates once more this year and then four times next year. That is slightly more hawkish than the FOMC’s own projections imply, but those forecasts don’t appear to factor in a fiscal stimulus. Beyond that, a lot still depends on who Trump picks to fill the other vacancies on the Fed’s Board. With Powell’s promotion, there will be four vacancies, including the Vice Chair position. Otherwise, the risk of a serious policy mistake – in either direction – will arguably be higher under Powell’s leadership than under Yellen’s. And policy communications may become more muddled, if Powell doesn’t provide strong intellectual leadership and the policy debate descends into a free-for-all among regional Fed Presidents.

Meet The Next Fed Chair: The Definitive Cheat Sheet

With the race for the next Fed chair in its final stretch as Trump is now expected to make his decision over the next few weeks, and following recent reports from Bloomberg, Politico and the WSJ, the three frontrunners to replace Yellen, according to PredictIt, are Kevin Warsh, Jerome Powell, Gary Cohn and unexpectedly, Neel Kashkari, following yesterday"s endorsement by Jeff Gundlach...

... Bank of America has put together a handly cheat sheet laying out a summary of the major views by the 4 key contenders.

Focusing on the top four candidates, BofA, predictably, sees Warsh as the most hawkish and most likely to change the way the Fed conducts monetary policy, leaning toward rules-based policy. BofA also thinks Warsh would favor a lower ultimate size of the balance sheet but would be a strong proponent of deregulation. Meanwhile, Powell is the establishment candidate who won"t "rock the boat" as his stance is consistent with the current framework of the Fed. As for Cohn, he would likely lean a bit more dovish and emphasize putting in place monetary policy to complement fiscal policy reform.

Here is the full breakdown, according to BofA, which shows just how "unconventional" Warsh is in the context of his peers.

With that in mind, BofA"s Michelle Meyer writes that the Trump administration presumably have two main goals when choosing the Fed Chair:

1. monetary policy to remain accommodative and


2. financial deregulation.

The ultimate goal is to generate stronger economic growth and prolong the business cycle. This puts Warsh and Cohn in a strong position as both have argued that the right set of monetary and fiscal policy can yield trend 3% GDP growth. However, Warsh may be perceived as more hawkish when it comes to monetary policy.

Below is BofA"s detailed breakdown of the "contestants":

Contestant #1: Kevin Warsh

Kevin Warsh is a lawyer by trade, who is currently a distinguished visiting fellow at the Hoover Institution and lecturer at Stanford. He was a Fed Governor from 2006 to 2011, which was the heart of the financial crisis. Prior to the Fed, he worked at the National Economic Council under the GW Bush administration and at Morgan Stanley as an investment banker. Since leaving the Federal Reserve, Warsh has published a number of op-eds where he has expressed his frustration with the Fed"s easy policy stance. Below are a few representative quotes from his op-eds and from the Fed transcripts.

Interest rate policy:

• Jan 2017 op-ed: "What would a well-conceived, rigorously implemented Fed strategy look like? It would be clearly delineated and broadly measurable. Its goals would be within the scope of the Fed"s policy tools, attainable over time and circumstance. Critically, the strategy would be squarely focused on the medium term, that is, the next several years."


• "Seeking in the short run to exploit a Phillips curve trade-off between inflation and employment is bound to end badly. …. The Fed should adhere to a concept I would term "trend dependence." When the broader trends begin to turn-for example, in labor markets or output-the Fed should take account of the new prevailing signal."

QE and balance sheet normalization:

• March 2009 on QE: "I am quite uncomfortable with the idea of purchasing long-term Treasuries in size. As the papers described to us, the benefits could well be quite small. My sense is the costs might not be."


• April 2009 on QE2: "…I oppose an increase in our Treasury purchases beyond what we did last time. In terms of the discussion about markets and their expectations that we had earlier in this round, Mr. Chairman, I think we should not be surprised that markets want more; and the more we give, the more they will want."


• Jan 2010 on B/S exit: "But I would be inclined to push down excess reserves so we can be more effective when we decide we have to make more-meaningful steps to remove policy accommodation. On the question of the long-run balance sheet in the steady state, I think we should "try to go home again." It is difficult, but I think that we should try to, and I think we should be pretty explicit publicly about that desire. I am concerned about the efficacy of our operating target."

Fed credibility:

• Jan 2010: "I think of our preeminent goals here as ensuring our credibility so that: we can increase control and the perception of control over policy rates; we can be perceived to be able to effectively tighten financial conditions; and we can find our way back to a balance sheet and a regime that preceded this crisis."


• Nov 2013 op-ed: "Full disclosure of its balance sheet and operations is essential to the Federal Reserve"s democratic legitimacy. But transparency in communications about future policy is not a virtue unto itself. The highest virtue is getting policy right. Given manifest uncertainties about the state of the economy, oversharing policy deliberations is not useful if markets are led astray, or if public commitments reduce policy makers" flexibility to call things the way they see them."


• Jan 2017 op-ed: "Short-term thinking and ad hoc measures by the Fed beget short-term reactions by financial firms, businesses and households. …. The Fed"s technocratic expertise is no substitute for a durable strategy. This make-it-up-as-you-go-along approach causes many Fed members to race to their ideological corners, covering themselves as hawks and doves. It causes economists to litigate a false choice between fixed policy rules and unfettered discretion.

Regulation and fiscal policy:

• Aug 2016 op-ed: "With the enactment of the Dodd-Frank Act, the Fed claims the mantle of reform. It now micromanages big banks and effectively caps their rate of return. The biggest banks" growth in market share corresponds to that of their principal regulator. "


• April 2016: "The U.S. should lead the world in driving a growth-enhancing agenda, and fast. Washington must pursue policies that create new demand, rather than sanction an economic tit-for-tat that merely diverts demand among contesting countries. Supply-side, structural reforms-including radical tax reform and pro-competition regulatory reform-would propel domestic growth, and show the world a better way forward. "


• Oct 2015 op-ed: "Efforts by the Fed to fill near-term shortfalls in demand through QE and so-called forward guidance have shown limited and diminishing signs of success. And policy makers refuse to tackle structural, supply-side impediments to investment growth, including fundamental tax reform."

Bottom line on Warsh: If appointed, he is unlikely to immediately change the stance of policy and would continue to call for a gradual increase in interest rates and reduction in the balance sheet. However, the tone of the FOMC will change with Warsh, showing a hesitance to discuss recent data or economic models and instead a focus on influencing medium term growth. We also think Warsh would look to announce a change to Fed communication, potentially adjusting the time period of the dots to remove the focus on near-term policy moves. We also think he would pencil in a higher long-run equilibrium Fed funds rate (R*) and emphasize the desire to return to a "pre-crisis" equilibrium for the balance sheet. The likelihood of the Fed delivering four hikes next year goes up.

Contestant #2: Jerome Powell

Like Warsh, Jerome Powell is a trained lawyer and not an economist. Powell has been a Fed Governor since 2012 and therefore was involved in the decision-making behind QE3 and then policy normalization in recent years. Prior to joining the Board, he was a visiting scholar at the Bipartisan Policy Center, a partner at the Carlyle Group, and worked at the Treasury under the GWH Bush administration. Powell has been a vocal member of the FOMC, giving regular speeches and appearing in the media. Here are the talking points:

Interest rate policy:

• June 2017: "The Committee has been patient in raising rates, and that patience has paid dividends. While the recent performance of the labor market might warrant a faster pace of tightening, inflation has been below target for five years and has moved up only slowly toward 2 percent, which argues for continued patience, especially if that progress slows or stalls. If the economy performs about as expected, I would view it as appropriate to continue to gradually raise rates."


• "In the case of the federal funds rate, the endpoint of that process will occur when our target reaches the long-run neutral rate of interest. Estimates of that rate are subject to significant uncertainty. The median estimate of its level by FOMC participants in March was 3 percent, more than a full percentage point below pre-crisis estimates."

QE and balance sheet normalization:

• June 2013: "Most research has found, and I agree, that the first round of purchases of longer-term securities, which began in November 2008, contributed significantly to ending the financial crisis and preventing a much more severe economic contraction. The second round of purchases that began in November 2010 also appears to have been successful in countering disinflationary pressures. Now that the financial crisis has receded and the economy is recovering at a moderate pace, are asset purchases still effective? In my view, the evidence across the channels is mixed, but positive on balance."


• June 2017: "To affect financial conditions, the Federal Reserve has therefore used administered rates, including the interest rate paid on excess reserves (IOER) and, more recently, the offering rate of the overnight reverse repurchase agreement (ON RRP) facility. This approach, sometimes referred to as a "floor system," is simple to operate and has provided good control over the federal funds rate. In November 2016, when the Committee discussed using a floor system as part of its longer-run framework, I was among those who saw such an approach as "likely to be relatively simple and efficient to administer, relatively straightforward to communicate, and effective in enabling interest rate control across a wide range of circumstances."

Regulation:

• June 2017: "Our objective should be to set capital and other prudential requirements for large banking firms at a level that protects financial stability and maximizes long-term, through-the-cycle credit availability and economic growth. To accomplish that goal, it is essential that we protect the core elements of these reforms for our most systemic firms in capital and liquidity, stress testing and resolution." Powell discussed five possible regulatory reforms.


• "The first is simplification and recalibration of regulation of small and medium-sized banks.


• "The second area is resolution plans. The Fed and the Federal Deposit Insurance Corporation believe that it is worthwhile to consider extending the cycle for living will submissions from annual to once every two years, and focusing every other of these filings on key topics of interest and material changes from the prior full plan submission."


• "Third, the Federal Reserve is reassessing whether the Volcker rule implementing regulation most efficiently achieves its policy objectives… there is room for eliminating or relaxing aspects of the implementing regulation in ways that do not undermine the Volcker rule"s main policy goals."


• "Fourth, we will continue to enhance the transparency of stress testing and the Comprehensive Capital Analysis and Review (CCAR)."


• "Finally, the Federal Reserve is taking a fresh look at the enhanced supplementary leverage ratio. We believe that the leverage ratio is an important backstop to the risk-based capital framework, but that it is important to get the relative calibrations of the leverage ratio and the risk-based capital requirements right."

Bottom line on Powell: Since joining the Fed, Powell has established a reputation as a centrist on the monetary policy spectrum, aligning his views with that of the consensus. In fact, he often references how the committee thinks (good practice for post-FOMC press conferences). Powell is a pragmatist when it comes to regulation, wanting to retain much of the post-crisis reforms but willing to revisit certain aspects that may have missed the mark, such as the Volcker rule. He would mean continuity at the Fed.

Contestant #3: Gary Cohn

Gary Cohn is the Director of the National Economic Council and Chief Economic Advisor to the Trump administration. He was formerly the COO of Goldman Sachs, having spent most of his career at the investment bank. He is not a trained economist. Cohn has been focused on tax reform but has been rumored to have the Fed Chair goal in mind. Press reports suggested that he was at the top of the list until September 6th when President Trump told reporters that he was "unlikely" to nominate him given a difference of opinions surrounding how the administration handled the Charlottesville event. More recent press reports indicate that he is still in the running. Cohn has not been as vocal on monetary policy as Warsh or Powell, but we put together some relevant commentary.

Monetary policy:

• April 2015 Bloomberg TV: He believes Yellen should be patient. She presumably has a desire to raise interest rates so that she has the ability to lower interest rates if something went wrong. But on the flip side, the Fed has a dual mandate and there is no sign of inflation in the system. He argues that Yellen may want to intellectually raise interest rates but will not be able to.


• Jan 2015 Bloomberg TV: He argues that there are currency wars as a result of global central bank policy. The US is just "watching" as other central banks devalue so our currency is appreciating rapidly. He argues that we are in a global economy where the prevailing view is that one of the easiest ways to stimulate economic growth is to have a low currency…which makes sense.


• Feb 2015 Bloomberg TV: He is not convinced that one good jobs report has changed the outlook. He thinks the Fed is going to be in a tough dilemma - will want to increase interest rates but will be constrained by circumstances and the strength of the dollar. Central bankers tend to need to see real inflation before hiking.

Fiscal policy and regulation:

• Sept 2017 CNBC interview: Expects the tax plan to bring about an enormous amount of growth. The plan will drive business back to the country and make the US more competitive. He thinks with tax proposal and deregulation, the economy can be "substantially" above 3% GDP growth. Economic growth will pay for the tax cuts.


• Oct 1, 2017 Fox Business: We started down a regulatory path which was our number one objective. We"re starting to have some wins on regulation. We"ve got a tax path…we"ve got infrastructure to do. The agenda is to drive the economy.


• Bottom line on Cohn: He would likely lean more dovish on monetary policy, looking to avoid a significant tightening of financial conditions. This means preventing significant dollar strengthening, higher rates or lower equity prices. On fiscal policy, he is clearly on the same page as the Administration with the goal of easing financial market regulation and implementing tax reform in an effort to generate 3%+ growth, which he believes is sustainable. In this respect, we would anticipate that his forecasts would be based on a longer business cycle, therefore implying a higher long-run equilibrium rate (R*).

Contestant #4: Janet Yellen

Current Fed Chair Yellen is also in the running as President Trump has been on the record praising her for her low interest rate policy. She also reportedly has a good working relationship with Treasury Secretary Mnuchin. Moreover, to the extent it matters, it is historic precedent to reappoint the sitting Fed Chair even after a change in the White House. Yellen"s policies are well known: she supports the gradual normalization of rates and the balance sheet. The balance sheet reduction is essentially on auto-pilot now and will continue even in the face of a weakening economy. She supports current financial regulation but has noted that there are policies that can be amended and that she would work with nominee Randy Quarles on adapting current regulatory policies to make them more supportive of fostering economic growth.

Would Yellen accept another term? We think she would. In our view, she would consider her job to be partly done and would like to complete the normalization process. When she accepted President Obama"s nomination, she presumably thought her term would last longer than four years. Moreover, she cares deeply about the integrity of the institution and maintaining independence from Congress, which she would be able to fight for.

* * *

Finally, here is BofA"s "prediction" on who the next Fed chair will be:

It remains a close race. Recent press reports suggest that Warsh and Powell have taken the lead.(*) We can also look to the betting markets: as of October 4rd, PredictIt showed about a 43% probability for both Warsh and Powell.

The reality is that it is still too early to tell and we should prepare for the potential of "dark horse" candidates. Moreover, while the focus is on the Chair spot, the Administration may also announce a nominee for Vice Chair and can work toward filling the additional three vacancies on the board (assuming Randy Quarles is confirmed in short order). The focus is on the Chair - as it should be - but there are several opportunities to influence the direction of Federal Reserve policy. Until there is clarity about Fed leadership, we suspect that market participants will be hesitant to take a strong position on medium term monetary policy.

A Look At US Government Shutdowns Since 1976

Investors and politicians are getting increasingly worried about a potential US government shutdown.

Earlier we showed that following a report by Axios which quoted a republican who put the chance of a shutdown "as high as 75%", the T-Bill market got spooked, and pushed the Oct.12 Bill - the one considered closest to the Treasury"s X-date - to the widest spread on record from the nearest "safe" Bill, maturing on Sept. 28.

And as more traders start asking questions, in the latest report laying out both the threat, and potential consequences from a government shut down and/or debt ceiling crisis, Barclays" Shawn Golhar tried to ease growing concerns and wrote that while Barclays "does not expect" either a shutdown or debt limit breach, he admitted that "the cumbersome legislative process, a limited number of Congressional working days in September, burgeoning tensions between President Trump and Congressional Republicans, and repeated demands by the president that any budget agreement include border wall funding raises the risk of a government shutdown and/or debt ceiling breach that goes against our baseline assumptions."

What makes the upcoming negotiations more complicated is that a potential government shutdown is a discrete event that is different from a debt ceiling breach, i.e. a technical default. In other words, in addition to lifting the borrowing capacity of the Treasury, Congress needs to complete the FY2018 budget process or pass a continuing resolution by October 1, 2017. If that does not happen, the federal government will shut down for the second time in the past four years.

The good news here is that despite the ominous rhetoric, short funding gaps are a regular feature of the budget process, even if they have become more pronounced in length in recent decades.

The Barclays chart below shows that since 1976, the federal government has experienced 18 funding gaps under the current budget process, "although most did not result in a shutdown of operations and a furlough of non-essential employees. Since 1980, following new interpretations of the law, government shutdowns have generally coincided with employee furloughs. This is particularly true during the three most recent lapses in government funding – November 1995, December 1995-January 1996, and September-October 2013 – which are often referred to as true shutdowns. Also, funding gaps do not solely coincide with divided government; five in the late 1970s occurred under one party rule."

Assuming the worst-case, and the government does shutdown on October 1, as it did briefly in September 2013, what then? In short, a shutdown would not have a sudden, adverse impect, but instead would subtract from US output slowly but surely. Barclays estimates that a shutdowns typically reduce real federal government consumption and gross investment 1.5% q/q and annualized GDP about 0.1% per week.

 Which is good news, because while the chart above shows that shutdowns occur with some regularity, their effects are largely political, particularly if the shutdown is short-lived. Furthermore, the lack of current income for millions of government workers and the political outcry to get a deal down at the grassroots level as government procurement contracts are put on halt, crippling downstream private industries, results in political pressure to reach a compromise. As a result, a shutdown would have to proceed for several weeks or more to have sizeable economic effects. Here are the details:

In the NIPA accounts, a government shutdown is primarily reflected in a decline in real compensation of non-essential employees as a result of reduced hours worked. In the 1995- 96 shutdown, approximately 800,000 of 2.04mn federal civilian (non-postal) workers were forced to take leave without pay, or about 39% of employees. In the shutdown of 2013, about 850,000 of 2.19mn federal civilian employees were furloughed (a similar 39%). That said, then-Secretary of Defense Gates ordered about 400,000 civilian military employees back to duty after the first week of the shutdown, leaving 21% of federal civilian employees furloughed in weeks 2 and beyond.

In addition to compensation costs, the effects of the shutdown are felt primarily in services consumption. A temporary government shutdown at the beginning of Q4 could result in shifts in investment spending from one month to the next and increase the volatility of inventory data, but would be unlikely to disrupt federal consumption of fixed capital and gross investment over the quarter as long as the situation were resolved before year-end. However, services consumption is unlikely to be recovered once halted. BEA estimates for non-defense expenditures unrelated to compensation are based on federal budget data, and a shutdown would be unlikely to alter these accounts unless it persisted past year-end or the BEA modified its procedures on applying annual budget data in its quarterly estimates.

So while a brief shutdown, one lasting 2-4 weeks would not cripple the economy, a longer shutdown "could have negative indirect effects on private sector activity."

* * *

What about a debt ceiling breach?

Here things are more serious: according to Barclays, the consequences of a debt ceiling breach as more extreme and, therefore, less likely. First, a quick look at lessons from recent history:

The debt ceiling showdowns in 2011, 2013, and 2015, like many before, have led to the use of extraordinary measures to create borrowing room and prolong the date at which the debt ceiling is reached. Extraordinary measures plus the Treasury’s cash balance left about $280bn in operating capacity as of the end of June, but these measures are only temporary; cash balances at the Treasury have gradually moved lower, and borrowing capacity will eventually reach its limit (Figures 3 and 4). Policymakers are running out of time as the September budget and mid-October debt limit deadlines loom. The exact timing of the end of borrowing capacity is uncertain, and the risk of an unforced error is rising.

While the exact timing of the so-called X-date is still fluid (we will have more on this a subsequent post shortly), one thing is clear: in addition to a potential downgrade by Fitch and Moody"s, it is the conomic consequences that would be most concerning: according to Barclays" calculations, failure to raise the debt ceiling would require an immediate cut in spending equal to about 3.5% of GDP (the federal deficit in percent of GDP in 2016 was 3.2%; the average of the most recent four quarters through Q2 17 was 3.8%).

Yet even cutbacks of this kind would not rule out a default because previous administrations concluded the Treasury does not have the authority to prioritize interest payments above other obligations. Even if revenues match expenditures in aggregate, federal receipts and payables differ in timing and quantity, and Treasury payment systems are designed to pay bills as they are received. Furthermore, even if the Treasury concluded it could prioritize interest and principal payments, it may still be viewed as a technical default since the government would not be meeting all its obligations.

In a separate report, the Bipartisan Policy Center calculated that losing the ability to borrow any more on Oct. 2 would mean approximately 23% of funds owed by the government that month would go unpaid, dealing an immediate blow to the U.S. economy.

Barclays" conclusion: "A contraction of federal spending of this magnitude, the risk of default, sovereign reputational risk, and negative consequences for confidence and private sector behavior would likely push the economy into a recession if the situation persisted. We view the consequences of a debt ceiling breach as extreme and, therefore, unlikely." Then again, a recession just 8 months into President Trump"s presidency may be precisely what all Democrats, and quite a few Republicans, desire, so we are far less sanguine than Barclays about an imminent "happy ending."

Only 4 House Republicans Say They Would Support "Clean" Debt-Ceiling Hike

With the CBO warning that the Treasury is on track to run out of cash in less than four months, Republicans are facing a difficult internecine struggle to raise the debt limits as both conservatives and moderates demand riders that stipulate how the money can be spent. And while the Trump administration has sought to play down this conflict, as the Hill reports, support for a “clean” debt-ceiling hike – that is, raising the debt ceiling with no strings attached – is dwindling as only a handful of the 16 remaining House Republicans who backed the last clean hike say they would back another. Yet, though Democratic support for a clean bill is far from assured, the Republicans’ much narrower majority in the Senate increases the likelihood of a clean hike.

Only 16 House Republicans who are currently in office backed the last “clean” debt hike, and few of them will say they are certain to support it this year. If the debt ceiling is raised with a clean hike — a distinct possibility given Democratic demands and the narrow, 52-seat majority for the GOP in the Senate, Republicans will need at least 24 members of their own conference to back a clean debt bill in the House.

That could be a tall order. Only four of the 16 Republicans who voted for the clean debt hike in 2014 suggest they will or are open to doing so this fall.

Even Paul Ryan voted against the last debt-ceiling bill in 2014 when he was Chairman of the House Ways and Means Committee. And in the Senate, every Republican opposed the bill the last time around. Given these odds, the chances of another round of downgrade-inducing gridlock are high – and the possibility of raising the US borrowing limit before Congress’s August recess, as Treasury Secretary Steven Mnuchin has repeatedly urged, are looking increasingly remote. The problem is compounded by the fact that this is the first time in 11 years that the GOP will be in charge of raising the debt ceiling while controlling both chambers of Congress AND the White House, meaning that the optics surrounding who “owns” the bill will complicate the voting process.

Furthermore, the Democratic leadership appears to be standing by its policy of obstructionism, unwilling to do President Donald Trump any political favors, according to the Hill.

That political dynamic puts all of the responsibility for raising the debt ceiling on the GOP, and little if any on Democrats. House Minority Leader Nancy Pelosi (D-Calif.) will not want to give slack to vulnerable Republicans who don’t want to back the debt ceiling hike for their own party’s president.

“I don’t see Democrats bailing out Republicans, just like Republicans didn’t bail out Democrats,” said Steve Bell, senior advisor for the Bipartisan Policy Center and a former staff director of the Senate Budget Committee. “They’ll say ‘we’re going to give you the same amount of help you gave us.’”

In the spring, Pelosi and Senate Minority Leader Chuck Schumer (D-N.Y.) suggested that Democrats could withhold support from a clean debt hike if Republicans separately press for legislation cutting taxes on the wealthy.

They later said that Democrats would back a clean debt hike, but Pelosi will want as many Republicans as possible to support it since their party controls the White House. And the tax talk has given an argument to any liberal who chooses to oppose a debt ceiling hike.

So far, only four of the 16 House Republicans who backed the clean debt ceiling in 2014 suggested they would consider voting for a clean hike – far below the 24 votes needed to pass such a bill. They are: Charlie Dent (Pa.), Darrel Issa (Calif.), Peter King (N.Y.) and David Valadao (Calif.).

Members of the Trump administration have expressed conflicting views on the debt ceiling. Mnuchin supports a clean bill, while Mick Mulvaney, a former House Republican who voted against the last clean debt-ceiling bill, has said there should not be a clean debt hike vote.

Conservative Republicans are already pressing Ryan to tie spending cuts or budgetary reforms to a debt-limit bill, signaling they do not plan on changing their strategy with fellow Republican Donald Trump in the White House. Meanwhile, the official Democratic position is to support a clean bill. If the House could pass a debt ceiling bill that includes provisions backed by conservatives, the Senate would need at least eight Democrats to back it in the Senate to overcome an expected filibuster.

The last time the US infamously shut down due to passing its debt ceiling was in August 2011, when S&P downgraded the US, formerly at a AAA rating, for the first time ever prompting a furious response from then-Treasury secretary Tim Geithner.

Of course, raising the debt ceiling is hardly the only issue where Republicans remain deeply divided. With Congress observing the July 4 holiday, they’re likely to get an earful from governors in the 31 states that expanded Medicaid, who say the Republican plan to repeal and replace Obamacare goes too far, according to the Wall Street Journal. Nine Republicans oppose the legislation in its current form – seven more than Senate Majority Leader Mitch McConnell can afford to lose.

Here"s WSJ:

Most vocal are governors of states that expanded their Medicaid eligibility under the Affordable Care Act. The bill would phase out that expansion and transform the state-federal safety-net program into one in which the federal government’s share would be capped. In all, the bill would cut $772 billion in funding for the program over a decade.

“It’s a pretty big deal, because in most cases these states have had bitter battles inside the state legislature and [with the] governor about [Medicaid], and it’s been settled in favor of expansion,” said Stewart Verdery, a former GOP Senate aide and founder of Monument Policy Group, a lobbying and public-affairs firm.

For any Republican senator “to blow that up from afar is really dicey,” Mr. Verdery said.

In Nevada, Republican Sen. Dean Heller, who faces a tough re-election fight next year, appeared with GOP Gov. Brian Sandoval at a news conference recently and said he opposes the health bill. Republican Gov. John Kasich of Ohio has said the bill’s opioid-addiction measures don’t go far enough, and he said he has conveyed his worries to the state’s GOP senator, Rob Portman. Arkansas Republican Gov. Asa Hutchinson said he has spoken to his state’s GOP senators, Tom Cotton and John Boozman, almost daily about his concerns with the bill.

And as we noted earlier, Bannon and the populist wing of the Trump administration is considering pushing for higher taxes on the wealthy – an issue that’s anathema to Republicans. With gridlock remaining the status quo in Washington, the Treasury has already begun holding larger cash balances in anticipation of deadlock, hoping to forestall the inevitable market shock should Congress blow past the CBO’s mid-October deadline.

The Treasury breached its debt limit on March 16, when the debt ceiling was reset to $19.8 trillion, however, so far there has been no new borrowing authority to surpass it. Since then the Treasury has been using so-called “extraordinary measures,” to pay bills without technically adding to the debt amount However, as Mnuchin has warned, many worry that waiting until the last minute to act on the debt ceiling could provoke a dramatic selloff in US stocks. Who knows? Maybe the debt-ceiling fight will be the straw that finally breaks the back of our ridiculously overvalued equity market.