The Floor Is Creaking

Budget Report: Thank You Sir, Can I Have Another

The U.S. is at the point where the floor of support for U.S. Treasuries will begin to sag under an increased amount of upcoming supply. According to the Congressional Budget Office (CBO) report out last week, the adjusted U.S. budget deficit will be a shocking $2.0 trillion for 2024. The more disturbing statistic is that their forecast increased by $400 billion since their last report. To repeat, since February, just four months ago, the CBO needed to increase the budgetary shortfall for yearend by more than 25 percent to $2.0 trillion. In 10 years, the deficit is estimated to be at $3.0 trillion, so the country is moving in the wrong direction regarding budgetary discipline.

The phrase “budgetary discipline” is becoming an example of an oxymoron in this country. The share of U.S. gross domestic product represented by interest payments on government debt is going to be 1.5 times larger than defense expenditures over the next decade due to rising interest rates. This is no longer a matter of bad headlines. We are approaching a point of no return because the more debt we issue, the higher the amount of interest we will be required to pay to attract investors.

The next quarterly refunding announcement is in one month, and with the $400 billion increase in the Treasury’s borrowing need, the amount of coupon issuance must rise. Treasury Secretary Janet Yellen has been issuing more short-term debt to keep from locking in high interest rates for the long run, which happens when the Treasury issues coupon securities carrying maturities from 2 years to 30 years. The problem is that auctioning more short-term Treasury Bills is a temporary fix, and there is a need to return to longer maturities to fund the budget. The last few times we have seen an increase in the amount of coupons auctioned, such as in August of last year, it sparked a stock market selloff of more than 10%. Now that the S&P 500 is 20% higher than the August 2023 highs, we may need to brace for an even bigger drop. The potential timing? Either on the announcement of the auction amounts at the end of July or sooner, as the market begins to discount the inevitability of that announcement.

Retail Sales: Consumer Spending is on Ozempic

The consumer is showing cracks from the strains of higher prices, dwindling savings, and increased concern over job security. The May retail sales report was weaker than expectations, rising only 0.1% versus April, and April and May were revised down by a total of -0.4%. Many pointed to a drop in gas prices as a depressant on the May numbers, but the large decline in housing related retail sales is what matters more. Sales of furniture and home furnishings fell 1.1% on the month, and 7.9% year-over-year, reaching their lowest level since December 2020.

Building materials were down 0.8% compared to April and 3% lower than in May 2023, reflecting lower housing demand (see the next Point below). Given the signs of reduced hiring from the recent rise in initial claims for unemployment insurance, coupled with small business plans to reduce compensation in their future hiring, labor income growth will be slowing. This is supported by the lower consumer confidence readings that have been released lately. Perhaps investors will turn their focus more forcefully on the weaker consumer only when the nonfarm payroll report headlines begin to show weakness, but the outlook from the consumer is clear: their anxiety is rising.

Housing: Sell Low

The investor adage of buy low sell high has been missed lately on Home Builders, as high mortgage rates are dampening demand. The National Association of Home Builders (NAHB) reported last week that 29% of builders reported cutting their home prices, the highest percentage since January, with 61% turning to sales incentives. Their Home Market Index had moved above 50 in March and April this year, reflecting a favorable outlook, but fell to a 45 reading in May. June was expected to rise but fell to its lowest level of the year at 43. Our favored data series in the report is prospective-buyer traffic, and it also fell to the lowest level this year. The six-month sales outlook has fallen from 60 to 47 in two months. May’s 9-point drop was the biggest since October 2022, when the stock market was over 50% lower than it is today. Furthermore, housing starts and building permits fell to a four-year low in June. Bullish equity investors are banking on strong labor demand to support consumption and solid earnings, just as home builders are hoping for the Fed to cut interest rates, making mortgages more affordable. At this point, the central bank may be forced to drop rates due to a deteriorating labor picture and a weaker consumer. That would certainly not be an optimal scenario for home builders.

What to Look for This Week

1. Over $210 billion in U.S. Treasury coupon securities are coming on the market looking for a home. At 1:00 pm E.S.T. Tuesday, June 25, Wednesday, June 26, and Thursday, May 27, $70 billion 2-year notes, $70 billion 5-year notes, and “only” $45 billion 7-year notes are auctioned, respectively. Some floating rate notes will also be sold to round things out. Given the dismal data of the CBO, the auctions may become more of an equity market-moving event than normal.

2. May’s Core Personal Consumption Expenditure Price Index (PCE) is released at 8:30 am E.S.T. Friday May 28. The Dallas Fed’s trimmed-mean PCE is released 30 minutes later and we will see the percentage of items comprising the PCE that are above 3% and 5% to get an idea of the future direction of that inflation indicator.

3. Off the beaten track, but going on the radar given the recent weakness in housing data, is Tuesday, May 25 Housing Price Index from the Federal Housing Finance Agency (FHFA) at 9:00 am E.S.T. Most people will watch the Case Shiller housing data released at the same time, but the FHFA data is more reliable based on the way the Index is constructed.