Image Source: Pixabay

The Debt-Ceiling Deal Is Done. Why Might A Recession And Stock-Market Drop Follow?

The recent debt-ceiling deal may not bring a significant relief rally to the stock market due to concerns of an impending recession. The combination of the Federal Reserve tightening monetary policy and the end of fiscal support measures implemented during the Covid-19 era is expected to contribute to an economic downturn later this year. The effects of easy money and increased government spending that fueled GDP growth, inflation, and the stock market are diminishing, leading to a potential fiscal hangover.

While the spending curbs included in the debt-ceiling deal are relatively mild, one detail stands out. Reports suggest that the deal will formalize the Biden administration's plan to end the freeze on student loan payments, which has supported spending over the past few years. This is likely to further slow down spending at a time when economic growth is already near-stagnation. Additionally, the Federal Reserve, prompted by higher-than-expected inflation, is expected to raise interest rates further, potentially tightening financial conditions.

The temporary relief from the debt-ceiling deal for investors is expected to be short-lived because the stock market is about to lose its own fiscal support. The inability of the Treasury to issue debt in recent months has counteracted the Federal Reserve's efforts to tighten financial conditions by reducing its holdings of assets purchased during the pandemic. However, with the debt-ceiling deal in place, Treasury issuance is set to increase significantly, leading to a more aggressive form of quantitative tightening by the Fed.

The debt-ceiling deal reached by President Biden and House Speaker Kevin McCarthy includes modest spending curbs compared to what House Republicans had proposed. The cuts focus on holding nondefense spending at approximately 2023 levels while exempting military and veterans' health spending. The deal also introduces stricter work requirements for adults without children to receive food aid, with exemptions for the homeless and veterans. Furthermore, it trims $10 billion from the additional $80 billion in IRS funding aimed at enhancing tax enforcement.

While the White House had anticipated some level of discretionary spending cuts in a debt-ceiling deal, it would have required the GOP-controlled House's approval for the 2024 budget before the start of the new fiscal year. Failure to reach an agreement could have resulted in a government shutdown, potentially exacerbating the risks of a recession.

The limited leverage of House Speaker McCarthy, who needed Democratic votes for any deal to pass, meant that pushing too hard could have prompted President Biden to explore alternative methods to bypass the debt ceiling, which could have had controversial implications.

How will a debt ceiling increase affect interest rates and gold?

The relationship between debt increase, interest rates, and gold can be complex and influenced by various factors. However, I can provide you with some general insights on how these variables may be interconnected.

Debt Increase and Interest Rates:

When the overall level of debt in an economy increases, it can put upward pressure on interest rates. This is because higher levels of debt increase the demand for borrowing, leading to a higher demand for loanable funds. In response, lenders may raise interest rates to match the increased demand and mitigate potential risks associated with higher levels of debt.

Moreover, an increase in government debt, specifically, can have an impact on interest rates. When a government issues more debt to finance its spending, it increases the supply of bonds in the market. If the demand for these bonds remains unchanged or decreases, the increased supply can lead to a decrease in bond prices and an increase in bond yields (interest rates move inversely to bond prices). This effect can spill over into other interest rates, such as those on mortgages and corporate loans, which can rise as well.

Debt Increase and Gold:

The relationship between debt increase and gold is more complex and can be influenced by various factors. Here are a few points to consider:

1. Safe-Haven Asset: Gold is often considered a safe-haven asset, particularly during times of economic uncertainty or inflationary concerns. When debt levels rise and there is increased uncertainty in financial markets, investors may turn to gold as a store of value. This increased demand for gold can potentially drive up its price.

2. Inflation Expectations: Rising debt levels can lead to concerns about inflation, especially if the debt is monetized or if there are expectations of future inflationary policies. Inflation erodes the value of fiat currencies, making gold relatively more attractive as a hedge against inflation. Consequently, higher inflation expectations due to increased debt levels can contribute to higher gold prices.

3. Monetary Policy and Interest Rates: Central banks often respond to rising debt levels by implementing monetary policy measures, such as lowering interest rates or engaging in quantitative easing (QE) programs. These actions can increase the money supply and potentially weaken the value of the currency. When the value of the currency depreciates, the price of gold, which is priced in that currency, may rise.

4. Market Sentiment: Market sentiment and investor perception of the relationship between debt levels, economic stability, and the value of fiat currencies can also influence gold prices. If investors perceive higher debt levels as a sign of economic instability, they may seek the relative safety of gold, driving up its demand and price.

How raising the debt ceiling may affect the economy?

The impact of debt increase on the general economy can be significant and multifaceted. Here are some potential effects to consider:

1. Economic Growth: Excessive levels of debt can hinder economic growth. When debt levels rise beyond sustainable limits, it can lead to a burden on the economy as resources are diverted towards debt servicing rather than productive investment. High levels of debt can crowd out private investment, reduce consumer spending, and limit the government's ability to stimulate the economy through fiscal measures.

2. Interest Rates and Borrowing Costs: As mentioned earlier, increasing debt levels can put upward pressure on interest rates. Higher interest rates can increase borrowing costs for businesses and consumers, making it more expensive to invest, expand businesses, or make large purchases. This can potentially slow down economic activity and dampen investment and consumption.

3. Government Spending and Taxes: Rising debt levels often lead to increased government spending on interest payments. As more money is allocated to service the debt, it leaves fewer resources available for other areas such as public infrastructure, education, healthcare, and social welfare programs. To manage the debt burden, governments may also resort to raising taxes or cutting spending in other areas, which can have implications for economic growth and social welfare.

4. Financial Stability: High levels of debt can pose risks to financial stability. If debt becomes unsustainable or borrowers struggle to repay their obligations, it can lead to financial distress and potential defaults. This can have spillover effects on financial institutions, credit markets, and investor confidence, potentially triggering broader economic downturns or financial crises.

5. Inflation and Currency Stability: Excessive debt levels can contribute to inflationary pressures. If governments resort to monetizing debt by increasing the money supply or engaging in expansionary monetary policies, it can erode the value of the currency and lead to higher inflation. High inflation can disrupt economic stability, reduce purchasing power, and impact living standards.

6. Investor Confidence and Sentiment: Rising debt levels can erode investor confidence and sentiment. If investors perceive a country's debt as unsustainable or anticipate potential fiscal or monetary challenges, it can lead to capital flight, currency depreciation, and reduced investment. This can negatively impact economic growth and stability.

Does an increase of the debt ceiling increase chances of a recession?

The increase of the debt ceiling itself does not directly increase the chances of a recession. The debt ceiling is a legislative limit on the amount of debt that a government can legally borrow to fund its operations. Raising the debt ceiling allows the government to continue borrowing and meet its financial obligations.

However, the reasons behind the increase in the debt ceiling and the overall level of debt can have implications for the economy and potentially impact the likelihood of a recession. Here are some factors to consider:

1. Fiscal Policy and Government Spending: If the increase in the debt ceiling is driven by excessive government spending or structural deficits, it can potentially strain the economy. High levels of government debt, particularly if not used for productive investments, can crowd out private investment and reduce economic growth. If the debt increase is not accompanied by measures to address long-term fiscal sustainability, it can create concerns about the government's ability to manage its finances effectively, leading to reduced investor confidence and potentially negatively impacting the economy.

2. Debt Sustainability: The sustainability of the increased debt levels is a crucial factor. If the debt increase is manageable and the government can service its debt without significant strain on the economy, the likelihood of a recession may not be directly affected. However, if the debt becomes unsustainable and the government struggles to meet its obligations, it can lead to financial instability, market volatility, and potentially trigger an economic downturn.

3. Interest Rates and Borrowing Costs: As debt levels increase, the demand for borrowing also increases. This can put upward pressure on interest rates, making it more expensive for businesses and consumers to borrow. Higher borrowing costs can reduce investment, consumption, and overall economic activity, potentially increasing the chances of a recession.

4. Confidence and Market Sentiment: The increase in the debt ceiling can impact investor confidence and market sentiment. If investors perceive the increase as a sign of fiscal mismanagement or a lack of long-term sustainability, it can lead to reduced confidence, capital outflows, and market volatility. This can negatively affect investment, consumer spending, and economic growth, potentially increasing the likelihood of a recession.

How does gold perform in a recession?

Gold has historically been viewed as a safe-haven asset, and its performance during a recession can be influenced by several factors. Here are some general observations regarding how gold tends to perform during economic downturns:

1. Store of Value: Gold is often considered a store of value during times of economic uncertainty. When investors are concerned about market volatility, currency depreciation, or financial instability, they may seek the relative stability and perceived intrinsic value of gold. This increased demand for gold as a safe-haven asset can potentially drive up its price during a recession.

2. Hedge against Inflation: Recessions can be accompanied by deflationary pressures or, alternatively, by inflationary policies implemented to stimulate the economy. Gold is often seen as a hedge against inflation, as its value tends to hold up better compared to fiat currencies during periods of rising prices. If investors anticipate inflationary pressures or lose confidence in the currency during a recession, they may turn to gold as a way to preserve their wealth.

3. Diversification Benefits: Gold's performance during a recession can also be influenced by its role as a diversification tool in investment portfolios. During economic downturns, traditional financial assets like stocks and bonds may experience significant declines. As a result, investors may allocate a portion of their portfolios to gold as a means to diversify risk and reduce the overall volatility of their investments.

4. Liquidity and Market Sentiment: The performance of gold during a recession can be influenced by market sentiment and liquidity conditions. In times of financial stress, investors may experience difficulties in accessing liquidity and may seek to liquidate their investments, including gold, to raise cash. However, the overall sentiment towards gold as a safe-haven asset can offset any short-term liquidity-driven fluctuations, providing support to its price.

It's important to note that while gold has historically exhibited certain characteristics during recessions, its performance can still vary based on specific economic conditions, market dynamics, and investor sentiment. Other factors such as central bank policies, currency movements, and overall supply and demand dynamics in the gold market can also impact its performance during a recession.

Investors interested in gold as a potential investment during a recession should carefully consider their investment objectives, risk tolerance, and consult with financial professionals to make informed decisions based on their individual circumstances.

Let's take a look at the gold standard deviation report for next week and see what short-term trading opportunities we can identify. This report is published in the MeanReversion section of investing groups.

Gold: Weekly Standard Deviation Report

Summary

• The weekly trend momentum of 2018 is bearish.
• The weekly VC PMI of 1975 is bearish price momentum.
• A close above 1975 stop, negates this bearishness neutral.
• If short, take profits 1943 - 1924.
• Next cycle due date is 5.30.23.

Weekly Trend Momentum:

The closing price of the gold futures contract was 1963, indicating that the market closed below the 9-day SMA of 2018. This suggests a bearish weekly trend momentum. However, if the market closes above the 9 SMA, the bearish short-term trend would be negated, shifting the trend to neutral.

Weekly Price Momentum:

The market closed below the VC Weekly Price Momentum Indicator at 1975, confirming a bearish price momentum. To shift the weekly trend to neutral, a close above the VC PMI is required.

Weekly Price Indicator:

Traders are advised to consider taking profits on short positions during corrections at the Buy 1 and 2 levels of 1943 - 1924. In case of a weekly reversal, going long may be a suitable strategy. It is recommended to set a Stop Close Only and Good Till Cancelled order at the 1924 level for long positions. Additionally, profits can be taken on long positions as the market reaches the Sell 1 and 2 levels of 1994 - 2026 during the week.

Cycle:

The next cycle due date is 5.30.23. Traders should take this date into account while formulating their trading strategies.

Strategy:

If currently holding short positions, it is advisable to take profits within the range of 1943 - 1923. On the other hand, if holding long positions, profits can be taken within the range of 1994 - 2026.

More By This Author:

Gold: U.S. Debt Surpasses $31 Trillion
An Inverted Yield Curve And The Price Of Gold
Retail Apocalypse: Gold And Silver Bottoms