The Daily Update - Yellen / Illinois

Yesterday we heard from Fed Chair Janet Yellen in what could be one of her last appearances before Congress. She acknowledged that the economy continues to grow (albeit slowly), jobs are being added and household consumption was up. However, Yellen believes that current Fed rate estimates would be lower ‘because the neutral rate is currently quite low by historical standards, the Federal Funds Rate would not have to rise all that much further to get a neutral policy stance’. Yellen also voiced concerns around inflation targets stating, ‘I do believe part of the weakness in inflation reflects transitory factors, but well recognise that inflation has been running under our 2% objective, that there could be more going on there’, adding that there was ‘uncertainty about when – and how much – inflation will respond to tightening resource utilization’. When asked by lawmakers about the Fed’s plans to reduce its balance sheet, she replied that it was ‘likely’ to begin this year.

This more dovish tone from Yellen has dampened markets’ expectations on the pace of rate raises. At time of writing the market rate probability is at around 10% for a rise in September, and the chance of a hike this year is now less than 44%. Indeed you have to go out to March 2018 to find the probability of a hike to be above 50%.

Also we learned yesterday that the US state of Illinois narrowly avoided being the first US state ever to be downgraded to junk by Standard and Poor’s (or indeed any of the big 3 rating agencies). Illinois avoided the downgrade by the skin of its teeth after it passed a budget last week where its lawmakers agreed to raise income taxes by a massive 32% and at least start paying its enormous USD15bn of unpaid bills. The budget allows Illinois to issue up to USD6bn of bonds to help pay at least some of its bills. With the passing of the budget after a two year deadlock Standard and Poor’s believes the state has lowered the risk of a ‘liquidity crisis’, leaving it one notch above junk. Although the rating agency have said the odds of any further downgrades within the next year have been ‘substantially diminished’ stating that the budget ‘reduces the near-term uncertainty that had come to characterize its financial operations’.

In the budget, spending is expected to be USD36.6bn whilst revenue is USD36.3bn, so still underwater by approximately USD300m whilst having USD15bn of unpaid bills! These figures, while huge, pale into insignificance when pension liabilities are taken into account. According to Moody’s, Illinois’ pension liabilities for retired state workers is over USD250bn.

The state is not out of the woods yet with regards to rating agencies. Fitch downgraded the state to two notches above junk in February, and Moody’s is reviewing its credit rating.  How did Illinois get into this situation? Well as Ted Hampton, a senior credit officer at Moody's said, ‘The massive pension liability results from a chronic tendency to defer difficult decisions’, adding ‘all of these problems are governance and management weaknesses’.

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