Macro analyst Richard de Chazal discusses Fitch’s U.S. government debt downgrade, the resilience of the American consumer, inflation insights, yield curve dynamics, and the global economic puzzle.

Podcast Transcript

Chris Thonis

Welcome to William Blair Thinking Presents, a new podcast series that aims to provide in-depth expertise from our award-winning equity research and capital advisory teams on today's financial and economic landscape. I'm Chris Thonis, head of equities, marketing, and media relations, and I'm delighted to be your host.

On today's episode of William Blair Thinking Presents, we welcome back macro analyst Richard De Chazal. Richard, thank you again for joining me. Always good to have you here. There's been no shortage of significant economic news recently, as always. So, let's touch on some of the key points. First off, the decision from rating agency Fitch to downgrade U.S. government debt from AAA to AA+ at the beginning of August. As you mentioned in a recent Economics Weekly, it preceded several days earlier by the Treasury's announcement that it would be issuing even more debt going forward than the markets had anticipated. Has this had any meaningful impact, in your opinion?

01:03- 01:26

Richard de Chazal

Thanks. Great to be here. I think that the move from Fitch at the start of August was certainly one of the more interesting things that has happened this month and probably raises a few questions. I think from the outset [we asked] does this actually matter? And I think this is something I started out with in that note you're just referencing.

The answer to that is probably that…it depends, which I think is actually the answer to just about every question in economics, is it's a bit like Schrödinger's cat. You know, it sort of matters and it doesn't matter. So, I don't think it matters in the sense that it's pretty doubtful that any bond traders would have been forced to sell their holdings of U.S. treasuries on the back of this downgrade.

01:52 - 02:21

And also, I think, due to the fact that the U.S. is never going to unintentionally default on its debt. So remember, the U.S. importantly, has control of its own monetary policy. You know, it has a floating currency. All of its debt, again, is in its own currency and is still the world's reserve currency of choice. And I think that's something that's going to remain the case for quite a while to come.

Judging it against countries like Germany or the Netherlands, which are triple-A but that don't control their own monetary policy or are trapped in the currency union, if you will, isn't quite an apples-to-apples comparison. So, from that perspective, you know, a change in a U.S. rating probably doesn't matter all that much in the market just moves on per se.

But I think what does matter is that this move has been pretty useful in highlighting the fact that the Treasury probably can't get away with just doing whatever it wants, whenever it wants. So ultimately, the debt, the U.S. issues matter. It's not to infinity and beyond. And what it's also done is to highlight that the supply and demand dynamics for Treasury securities in the near term have really deteriorated.

One thing Fitch was worried about in their note was the ongoing debt ceiling shenanigans, which once again highlighted how dysfunctional things are in Washington. And I think sadly, as long as that brinkmanship continues, it raises the possibility for an intentional default. So, in the sense that if policymakers decide not to increase the ceiling, the result would inevitably be a government default on debt.

03:48 - 04:20

You know, after all, sort of extreme measures were taken. And I think what Fitch is clearly suggesting and something we can all sympathize with is we're seeing probably too much of this brinkmanship over the last few years, and that's somewhat unbecoming of a AAA-rated country. And I think maybe the second thing that you mentioned earlier was a greater sort of expected debt issuance from the U.S. Treasury.

So that's been another big issue for the market and probably the bigger issue, if you will, rather than the Fitch downgrade itself. So, the Treasury basically told us at the end of July that for the July through September period, total debt issuance would be a little above a trillion dollars and that's much higher than the guidance it was giving in May for around $733 billion.

04:46 - 05:14

And the CBO, Congressional Budget Office, they also raised their forecasts for the budget deficit for this year from one and a half trillion to 1.7 trillion. So that's pretty chunky increases. That's largely been due to lower-than-expected revenues, bigger spending and remember that the Treasury is also trying to rebuild its savings account at the Fed, so it's TGA (Treasury general account).

So that's creating a lot more supply coming to the market so that's not great from a supply perspective. And I guess what hasn't helped so much is it hasn't been particularly obvious that the Biden administration is, you know, massively concerned about this. They're not paying a lot of lip service to reining in future deficits now that the pandemic spending is over.

So, I think the market hasn't really appreciated that. And then if you think that's the supply side, on the demand side, I think the bond market also has some legitimate concerns here as well, that maybe we're starting to see some dynamics shifting here, too. I think in recent years, a lot of the demand for treasuries has been from, I guess you could say, price-insensitive buyers.

06:07 - 06:32

So, like foreign central banks, regulated banks, and insurance companies, that kind of thing. And I think the concern now is that some of that demand is diminishing. This sort of famous foreign savings glut that was a huge source of demand for treasuries is starting to moderate. So the Chinese, for example, are potentially lining up on their purchases.

The Japanese, who are the largest holders of government bonds, are also starting to tentatively move away from the yield curve control, which they've had for a while. So that potentially raises interest rates there, which makes JGBs (Japanese Government Bonds) a little bit more attractive. And I think lastly, the Fed has, of course, been the elephant in the room when it comes to sucking up new treasury issuance.

06:59 - 07:25

And, as you know, we've been doing or it's been doing QT for a while now, it's running down the size of its balance sheet. So, that's no longer providing much support either. So, the upshot being is there's definitely more supply, seemingly not a lot of concern about that coming out of Washington. On the demand side, we're seeing some waning demand from some of the most price-insensitive buyers.

So that's kind of culminating and pushing these yields a little bit higher. And I think maybe just to broaden the discussion a bit, I think my feeling is that, you know, in the near-term government debt and treasury issuance is concerning and certainly needs to be addressed. Maybe the bigger picture is, though, that we're still in a world where the economy's capacity to grow, so its potential rate of GDP growth, is still above the interest rate that we're paying on the debt.

Mathematically, that would suggest that for the moment that's still sustainable. But I think what we've seen in history is that scenario is not written in stone. It's not always the case. And I think while there's sort of no known tipping point, if you will, where the markets suddenly decide that U.S. debt to GDP is too large and you get a rate shock and a default, the kind of things that you see in an emerging market.

08:25 - 08:47

But what you are seeing are rates kind of pushing a little bit higher. And obviously, as that happens, it increases the amount the U.S. has to pay in net interest costs, which is a really sort of unproductive use of taxpayer dollars. And those higher interest rates also help to moderate growth. It's something we're concerned about watching closely.

It's clearly not helpful. It's tightening financial conditions which then impact the economy and sort of lead to slower growth. And the Fitch rating is really just a useful tool shining a spotlight on that situation.

09:02 - 09:27


Got it. So moving along would love to talk a little bit about the state of the consumer. July's advanced retail sales report, in particular, came in well above expectations on the headline rate. And in a recent note, I think you noted that this data showed a consumer that is still hanging in there with low unemployment and steady income, excess savings, confidence that seems to be recovering as the economy continues to defy recession predictions. From your point of view, how likely is it that this is going to continue?

09:31 - 10:08


Yeah, that's clearly the big question. I think they've clearly been holding up pretty well. So there hasn't really been this kind of deterioration in consumer spending that had been expected, say, at the beginning of the year. Whether or not that continues, I think really depends on what's been driving this in the first place. I know in a note I wrote earlier, if you look at what might be some of the main supporting factors driving consumer spending or supporting that, I think you can pretty much break it up into, say, four baskets.

One is income and employment, so changes in wages and salaries, savings. So how much have consumers really put aside and how willing are they to enable to do that. Credit growth, so how much they're willing and able to borrow, how much future demand can they pull forward into the present, and what I also think is important is consumer confidence.

That kind of gets knocked a bit sometimes, but it's kind of the classic Keynesian animal spirits. If there's less certainty about the future, households will tend to save more and can reduce spending. So, you end up with this sort of paradox of thrift kicking in and what I think we've been seeing recently is consumption has been driven by savings.

So those excess savings that we got following the pandemic when we had this sort of forced restrictions and government stimulus coming through. But those savings are now being close to being exhausted. And we'll probably have an empty tank later this year or early in 2024. And following along from that, we've also had strong consumer confidence. As the threat from the pandemic faded, real incomes have been improving and consumers have been keen to kind of get out and undertake some of this revenge travel and spending.

11:34 - 11:56

But, again, I think that's been kind of taking place over the summer, and I suspect that fades as we move into the autumn period. You know, we've had these family reunions, everyone's done the trip to the remote island, and I think we'll start to see a little bit of a hangover come in the autumn as credit card bills maybe start to roll through.

And then again, on the credit side, consumers generally haven't really been taking on much credit since the pandemic, in part, I think because of those excess savings. And now what we're seeing is if they actually want to take on more credit, they're being faced with sky-high borrowing rates and banks that have been significantly tightening their lending standards. I think it is pretty incredible, looking at credit card rates recently.

And those are up at 21%. And mortgage rates, you know, they've been following the ten-year up. They're now at 7.6%. So that's clearly not helpful. You know, it's certainly something the Fed kind of wants to see to help cool this sticky inflation, but it's not supportive of stronger growth in consumption in the near term. With the influence of those kind of diminishing, we're now back to having consumption driven by real income growth, which encouragingly has finally turned positive as inflation has moderated.

13:05 - 13:33

So that's still a pretty big driver for consumers. But whether that remains the case, that will largely depend going forward on corporate profitability and corporate profit margins. And I think here, margins over the last few quarters have been given a helping hand by inflation, which has then meant that they've been able to hoard labor in this kind of tighter labor market environment.

Interest costs have also been low. But now the question is if inflation's coming down and the impact from higher rates is now starting to bite as well, how much pressure do we start to see on those margins? And how much do companies how much are they forced to start managing their costs, which in turn would then put more pressure on them to start cutting those costs, letting go of some workers, and we start to see the unemployment rate move up a bit and, you know, a reduction on consumer spending kind of that way.

14:11 - 14:32

And I think, just to add a couple more points, is I think also in the near term, we've had a couple more sort of headwinds coming at us. So the first is over the last month or so, we've seen a big increase in gasoline prices. Those are up about 10% since their low, I guess in early July.

And the second big headwind starting really in October is that about 40 to 45 million consumers will once again have to restart paying off their student debt loans. So that's pretty significant. And I think what was interesting is, is in the latest Consumer Pulse Survey from my colleagues in the consumer team of the research department, they came out with their latest report and, you know, they surveyed consumers.

It showed that back to school spending, you know, once again, is going to be pretty strong in August, but then it peaks. But I think what their survey also showed was they asked some questions around the student debt issue and how significant that's going to be. And they found that that basically the average payment that's going to start going forward is about $300 to $350 per month, which is largely concentrated in younger, higher-income consumers.

But again, that's kind of chunky and should be a bit of a drag on discretionary spending going forward. So I guess I would say net-net, I think we're looking at a consumer that at the moment is not, you know, badly positioned, but they're facing some headwinds going forward. Meanwhile, a lot of what were previously tailwinds are also now, at the very least, starting to wane a little bit.

16:03 - 16:23


So we touched a little bit on inflation, but I want to open that up a little bit. You mentioned in your recent Market Monitor that recent CPI data from the Fed was further evidence that inflation is slowly moderating, helping to ease pressure on the Fed to tighten further. Can we jump into that a little bit, especially as some of your more important takeaways from this month's report. And then as a second part to that question, we’d love to know what your expectation is for future raises.

16:29 - 16:57


Sure. I think the last inflation report definitely encouraging, but I also think the message was, you know, we're not quite out of the woods just yet. So core inflation that nudged down a bit from 4.8 to 4.7 on an annual rate of change. And while that's down from the peak of 6.6%, which we saw in, I think September, we're still not at the 2% target.

And I also think one of the problems is that if you scratch a little bit below the surface, you can see that the improvement we've seen so far, it's largely been built on the back of improvements in the supply side of the economy compared to the demand side. So for example, a neat way of actually seeing this is to look at data from the San Francisco Fed, which kind of chops up the CPI report and the price indices underneath the hood there and looks at goods and services and breaks them up into supply and demand driven buckets of inflation.

And I think what we can see from those is that so far just about all of the heavy lifting has been done from those supply-side factors. So that's basically the COVID restrictions have eased off. Port traffic, you know, has been clearing, orders are getting filled, that kind of thing. And I think what that implies is that we've probably now seen the easy gains of inflation, moderation being made, and now the battle starts to get a little bit harder on those stickier parts of inflation.

18:04 - 18:37

The final mile on inflation could be a slightly harder slog. And we're starting to battle that at the moment. So, for example, if you look at prices, you know, on the demand side, those are still running pretty hot and they're really just a little bit off the highs that we saw previously, which I think to me suggests that it hasn't really been the Fed's rate increases that have been biting in bringing down inflation just yet.

It's been more of those supply side dynamics, basically, supply chains clearing up. And I think that's important because it goes back to what we were talking about earlier, what's been driving the consumer and how resilient they've been so far. And I think it also means that this next set of gains on inflation will likely depend more on sort of getting a tangible slowdown in employment and income.

And that's obviously going to be a bit more painful and it's also something we're just tentatively starting to see. It's slow, but it's happening. So then to get to your question on the Fed, I think what it means there is that it'll probably see this as evidence that it's still a little bit early to do a full pivot just yet.

So it's still kind of in this wait-and-see mode until it really gets more definitive evidence that those stickier demand-related prices are, I guess, more definitively coming down.

19:40 - 19:57


In a similar vein, you noted that the yield curve has started to tentatively re-steepen with the long end rising. This is a bear steepening as opposed to what traditionally signals the start of a recession, which is a bull steepening and that's when short rates finally start to fall as it becomes obvious that inflation is no longer a problem.

And it's time to pivot back to supporting growth, just digging into the significance of that a bit?

20:03 - 20:27


Yeah, I think that's right. I think we've all been kind of expecting this sort of bull steepening or where short rates start to fall as the market starts to sense that the Fed has done enough, that the economy is slowing, we're moving into recession, and then long rates kind of fall by less as we head into the recession.

And that's I think normally how the cycle plays out as we kind of enter this kind of harder landing scenario. And again, I think what we're seeing today really boils down to two things. First, as we just discussed, the bond market is worried about the slew of new bond issuance on the supply side and the seemingly little motivation to scale that back.

And then on the demand side, it's worried about the falling international demand for treasuries from the likes of China and Japan and then the Fed doing QT. So, the private sector is having to take up more of the slack there. But I think to do that, it needs or wants slightly more attractive yields. But I think the second factor is a little more broad and relates to what you might think would be the lags in monetary policy.

21:21 - 21:57


So, for example, I think historically the view was that monetary policy has lags of anywhere from sort of 12 to 36 months. And there's a recent note out from the Kansas City Fed on this, and they basically found that the lags had decreased. They found that since 2009, the use of forward guidance, which is effectively the Fed kind of jawboning the market before actually undertaking any tightening or easing moves.

It found that the lag since 2009 had been reduced from about three years to about one year. But I think what's interesting, I think this time around with consumers not having taken out a lot of credit, so they're less credit sensitive or less sensitive to rates maybe this time around and those rates have been locked in when they hit these ultra-low COVID period, and they've had this excess savings.

22:30 - 22:58

So, what I think that's meant is that the lags this time around are actually pretty long. Again. And I think that's pretty much the opposite view of what the market seems to be thinking right now, where its view is really that the lags have become really, really short. And much of the tightening that the Fed's done has already been absorbed into the market, which is paving the way for this kind of perfect soft landing.

And I think part of the reason the market is thinking that is maybe we've been so conditioned by the last two economic recessions where one was sort of a major financial crisis, another was a major pandemic, and everything kind of collapsed sort of at once. You know, that's not really happening this time around. I think what we're seeing is, again, this kind of classic textbook-type economic cycle playing out where higher rates don't really hit all parts of the economy at the same time.

So, we're kind of seeing the impact rolling through the economy, where the slowdown is playing out in different parts of the economy at different points in time. So it's not all happening at once. And I think it's also worth remembering that it's really only been 18 months since the Fed actually started raising rates. So historically, that's when these policy lags really start to kick in.

23:59 - 24:26

Maybe what we're seeing isn't actually so unusual, but I think today this kind of short lag relief is what's being reflected in the market. So, you know, short rates are kind of going nowhere because inflation is moderating and that means the economy's going to have a softer landing. The market thinks that recession is now off the table, so then long rates are moving up.

That's why we're seeing this kind of bear steepening. And I think we're probably getting near the point where these longer-term yields are actually now starting to look quite attractive.

24:38 - 25:00


That’s a good point to end on is how all of this has culminated in indices of economic surprise for the United States still being exceptionally high. So an example of that is economic data has turned out to be much stronger than expected. You mentioned that this is at odds with the rest of the world indicating that either U.S. growth will start to disappoint, or the rest of the world will start to improve. Would love your take on that.

25:03 - 25:26


Sure. I think it's that's one of these interesting anomalies when we look at charts and data and economic data that we're seeing at the moment. We've kind of seen this decoupling going on where if we look at indices of surprises in economic data, so does the data come in above expectations or below expectations?

A positive or negative surprise, those can be turned into positive or negative surprise indices. And I think what we're seeing there has been growth has been surprising continuously to the upside in the U.S., but we haven't seen that similar move across other developed economies. So like Germany, Japan, the U.K. and I think perhaps most importantly, China, that hasn't really been the case.

And I think these economies are really struggling. In the last couple of weeks, we've really seen this taking place in China. So, China's moved back into deflation. Policymakers, they're having to cut interest rates to try and avoid a really hard landing. And I think that's kind of been the result of this implosion of this property bubble that they've had there.

They're seeing infrastructure growth scaled back considerably. And on the back of that kind of debt issues from those two areas that the important shadow banking sector is now in a bit of trouble as well. And I think another factor and I'm kind of wandering a bit here, but I think another factor on the China thing that is interesting is what we're probably seeing happening is some repercussions of what were really these ultra-extreme restrictive measures that the government took as a result of the COVID against this population.

So, I think like the U.S., you've got this kind of spike in savings. But unlike the U.S. and now there are sort of Western developed economies, what we're not seeing is this kind of post-restriction, post-COVID surge in spending as the economies have been freed up again. I think consumers there were so frightened and worried about what was being done to them.

27:28 - 28:05


They're now kind of keeping more money tucked under the mattress, kind of afraid to spend it. Once again. They don't have quite the social safety nets that, you know, we do in the West and that's causing major problems for growth in China and the economy. The government is really trying to try and fight this and support growth. And I think getting back to your original question, what history shows is that these sorts of major global periods of decoupling don't typically last for long periods of time.

And I think given what I think is going to be more of some lagged effects of monetary policy in the U.S. catching up or biting in the coming quarters, unfortunately, I think what that means is it'll probably be more of a case of the U.S. starting to disappoint than the rest of the world, starting to catch up on positive economic surprises.

It'll be interesting to see how this plays out and certainly something I'm sure we'll discuss on future podcasts in the coming months.

28:38 - 28:47


Perfect. Richard, as always, it's been a pleasure catching up. Looking forward to next month. In the meantime, have a great one and we'll talk soon.


Great. Look forward it. Thanks, Chris.