Dow Future stumbled even after the provisional debt deal

Wall Street Futures jumped Friday on hopes of an imminent US debt deal and generative AI optimism. Further late Saturday, the Biden admin reached the debt deal ‘on principle’ with House Republicans Majority Leader McCarthy after days of political soap opera. The US is on a holiday (Memorial Day) Monday and thus Congress is aiming to prepare the legislative text by Wednesday so that it could be passed by both houses of Congress before reaching President Biden’s table for final signature by Saturday (3rd May), well before the latest X-date (doomsday) of 5th May, set by Treasury Secretary Yellen.

This was the 79th time it's been raised since 1960 (almost every two years as per political permutation & combination); usually, even if one party Democrats and Republicans win both House and Senate in a Presidential election, it loses either House or Senate in the subsequent mid-term election after 2-years due to incumbent wave. Thus the ruling majority party usually turns into a minority government after the mid-term election. In any way, it also often causes U.S. political & policy paralysis, affecting financial stability in not only the U.S. but also globally as USD/UST is the preferred global reserve currency/debt.

Both Democrats and Republicans are quite dependent on each other and usually settle the debt deal to enhance the credit card limit of Uncle Sam every two years after days of political negotiation as per their respective economic/political agenda. The present cred card (debt) limit of the U.S. is around $31.4T, and after the budget/debt deal agreement, the limit may be kept as suspended till Dec’24, while Federal spending will be capped for the next two years. The agreement keeps non-defense spending roughly flat for FY23-24 and removes budget caps after Dec’25.

The spending levels reached reflect those the Biden admin had negotiated at the end of the last calendar year, thereby averting a potentially catastrophic 22% cut in non-defense discretionary priorities and a decade-long set of caps. The budget deal includes full funding for veterans' medical care and elevates funding for the toxic exposure fund over 2024 levels.

Despite Republican requests, the agreement does not incorporate any alterations to Medicaid. It does, however, modify SNAP (food stamp) aid time limits, gradually implementing and then sunsetting them for recipients up to age 54. Additionally, reforms are introduced to lower the number of vulnerable people of all ages subject to time limits.

The Inflation Reduction Act funding remains intact for clean energy funds for low-income Americans and pollution cleanup. As the US Supreme Court considers a significant student debt case, the resumption of student loan payments has been put on hold. The agreement has a few stipulations for lower-income Americans, including the introduction of extra work requirements. There's uncertainty around funding for the IRS, but House Speaker McCarthy announced there are no new taxes or programs in the deal. He hailed it as achieving 'historic reductions in spending'. Biden and McCarthy are it an 'agreement in principle' as there's always a chance of some minor changes in the final legal text but above are the main points. The two-year deal would also push the next political fight over raising the debt ceiling until after the Mov’24 U.S. Presidential election.

Highlights of the in-principle agreement over debt limit:

·         The agreement in principle will lift the debt limit for two years and roughly cap non-defense spending to current fiscal year levels for 2024 and increase it by 1% in fiscal year 2025

·         As part of the deal, the White House has also appeared to have made concessions to House Republican negotiators on work requirements for people receiving food stamps

·         The agreement reached on Saturday phases in food stamp time limits on people up to age 54 that will then sunset in 2030, while also exempting veterans and people who are homeless from these limits

·         The current work requirement for the program formally called the Supplemental Nutrition Assistance Program or SNAP, only applies to certain adults between the ages of 18-49

·         The agreement does not make any changes to Medicaid and prevented certain changes to the Temporary Assistance for Needy Families (TANF) program called for by Republicans

·         The agreement does not make any changes to Medicaid and prevented certain changes to the Temporary Assistance for Needy Families (TANF) program

·         A provision to impose new work requirements for certain social safety net programs had remained a final sticking point. Republicans had been pushing the issue hard, saying beneficiaries of programs, such as food stamps, who do not have dependents, should be forced to follow new rules. Democrats, however, had cast that idea as an attack on poor people

·         The bill would include an administrative pay-as-you-go provision to require that Biden finds offsets for rules and regulations that increase federal spending. It would slash the fiscal year 2023 funding request for new IRS agents, and claw back tens of billions in unspent funds meant to combat the COVID pandemic

Now the market focus would be the actual Congressional passage of the 79th debt limit deal amid political squabbling:

·         House Minority Leader Jeffries: Biden and House Rep. Speaker McCarthy will speak later to finalize the debt-ceiling deal text

·         Biden: House Rep. Speaker McCarthy and I reached an agreement in principle

·         Biden: I just spoke with House Rep. Speaker McCarthy, and we have a bipartisan budget agreement ready to go to Congress

·         Democratic Rep. Hime: Small scope of the debt-ceiling bill may win support from Democrats

·         After weeks of negotiations, we have agreed in principle. We still have a lot of work to do but I believe this is an agreement in principle that is worthy of the American people- McCarthy

·         House Rep. Speaker McCarthy: I expect a majority of House Republicans to vote for a debt-ceiling bill

·         House Rep. Speaker McCarthy: We're spending less than last year

·         House Rep. Speaker McCarthy: Debt ceiling agreement is a step in the right direction. It includes pay-go restrictions for the US Administration

·         House Rep. Speaker McCarthy: More than 95% of House Republicans are very excited about the debt ceiling deal

·         House Rep. Speaker McCarthy: There is so much in the debt ceiling deal that is positive

·         Texas Rep. Roy: We're going to try to stop the debt ceiling deal in the House

·         House Rep. Speaker McCarthy: I expect a vote on the debt limit deal on Wednesday

·         House Rep. Speaker McCarthy: I will brief Senate Republicans on the debt ceiling agreement later on Sunday

·         GOP House Rep. Graves: Biden and McCarthy won't talk until debt-ceiling bill text is out

·         Biden when asked if there are sticking points in the deal: None

·         Biden: I'm confident the debt-ceiling deal will get to my desk

·         US Senate Majority Leader Schumer: Senate Democrats to receive a briefing on the debt-ceiling deal from the White House later

·         Biden: Removing the debt limit would cause additional controversy

·         Biden: We did not compromise on the debt ceiling, but we did compromise on the budget

·         Biden: The agreement eliminates the worst-case scenario, a default

·         Biden: This agreement is excellent news for the American people

·         The debt-ceiling agreement amounts to a compromise on budget - White House

·         The agreement will neither cut health coverage nor increase poverty - White House

·         In the debt deal, IRS funding would be decreased by $20 billion over 10 years - White House

·         The agreement includes a debt limit suspension until January 1, 2025 - White House Official

·         The Biden administration does not expect the IRS's capabilities to change in the near term as a result of the budget agreement; the agency may need to seek additional funding in future years - White House Official

·         US house rules panel to meet on Tuesday afternoon to discuss the debt ceiling bill

·         The New Democrat Coalition leadership team supports the debt agreement

·         Biden waves off Republican concerns about defense spending: If more money is needed it can be appropriated

·         Biden: I am feeling good about prospects for passage of the debt ceiling deal

Late Saturday, U.S. President Biden issued an official statement on the Bipartisan Budget/debt limit agreement in Principle:

“Earlier this evening, Speaker McCarthy and I reached a budget agreement in principle. It is an important step forward that reduces spending while protecting critical programs for working people and growing the economy for everyone. And, the agreement protects my and Congressional Democrats’ key priorities and legislative accomplishments.

The agreement represents a compromise, which means not everyone gets what they want. That’s the responsibility of governing. And, this agreement is good news for the American people, because it prevents what could have been a catastrophic default and would have led to an economic recession, retirement accounts devastated, and millions of jobs lost. Over the next day, our negotiating teams will finalize legislative text and the agreement will go to the United States House and Senate. I strongly urge both chambers to pass the agreement right away.”

House Republicans circulated a fact sheet of the details of the debt limit agreement to House and Senate Republicans Saturday night after announcing the deal. The fact sheet says the agreement will cut spending year over year and set a 1% top-line number for the next six years at one percent growth. It also includes SNAP and TANF work requirements.

On late Saturday, Fed’s Goolsbee said:

·         The Fed is improving on the inflation goal, but we have not succeeded

·         With banks already on edge, calling Treasuries into question isn't good for the economy

·         If you just look at rates, you already see fear and uncertainty

·         Even anticipation of problems with the debt ceiling has consequences in financial markets

·         We will receive a lot of data between now and the June FOMC Meeting

·         I try not to prejudge rate decisions

·         I think we can bring inflation down without a recession

·         There's no doubt inflation is too high, and we're trying to get it down without starting a recession

·         The Fed's actions take months, or years, to work their way through the economy

Market wrap:

On early Monday, in a holiday-thinned trading day, Dow Future jumped over +90 points to 33265 on debt deal optimism, but soon stumbled and closed around 33167, almost flat on the concern of some uncertainty about the actual passage of the bill in Congress as even a small number of U.S. Lawmakers may delay it due to razor-thin Congressional margin between Democrats and Republicans. The market is now also concerned about the Fed hike in June as the U.S. debt limit fiasco is virtually over.

Conclusion:

Expect a last-minute debt deal passage after the political war of attrition gets over in line with respective political compulsions. Both Democrats and Republicans would be squarely blamed if there is any real U.S. debt default and subsequent chaos in the financial market. The US has raised the debt ceiling 78 times since 1960 and has never once defaulted while continuing the vicious cycle of huge deficit spending, borrowing, and printing without causing much inflation thanks to China’s cheap export from the 1980s (after China joined WTO). The global reserve currency status of USD is also a great advantage for ‘Uncle Sam’; everyone/country needs USD as it’s the ‘king’ and thus USD is always in demand despite almost 24/7 printing by the Fed; EUR and Chinese Yuan are far behind USD as far global reserve currency status is considered.

The U.S. is now paying around 9.5% of its tax revenue as interest on public debt and can’t afford to increase the same well into double-digit around Japan’s 15%; China and Europe are now paying around 5..5% of revenue as interest on the public debt (deficit spending). Thus the Fed has no option but to pause soon after a possible hike in June but Biden admin also has to reduce elevated inflation by fiscal action.

Apart from monetary action to reduce demand, the U.S. also needs proper/targeted fiscal stimulus/action to increase the supply side of the economy. But such supply-side reform/stimulus needs bipartisan political agreement, whereas present political and policy paralysis is hampering such initiative. Biden admin (Democrats) is now a minority government and has to depend upon the political whims & fancies of opposition Republicans. The same was true when the Republican Trump admin was turned into a minority government after two years of the mid-term election. The U.S. needs some political/legislative reform to allow a stable government to operate for at least 4/5 years (like India) without causing political & policy paralysis year after year.

At the present run rate, U.S. core CPI may take another 6 months; i.e. Sep’23 to fall to around +5.0% and Sep-Dec’24 to further fall around +4.0%, still substantially higher than Fed’s +2.0% targets. Thus Fed needs to keep the real interest rate restrictive /positive enough for a longer period, so that core inflation falls towards +2% targets by Dec’25. Fed may keep the repo rate at 5.50% by June for a real positive U.S. interest rate. Fed should have communicated earlier in a clear way that a real positive interest rate is the basic requirement for ensuring price stability along with supply-side actions by the fiscal authority/government (including peaceful resolution of the Russia-Ukraine/U.S./NATO proxy war).

Fed was already behind the inflation curve from early 2021 when the economy opens fully after the 2020 COVID disruption. Fed should have started to normalize its ultra-loose monetary policy in early 2021 rather than terming higher inflation as transitory and starting the process (telegraphing about QE ending and potential rate hikes) in late 2021. In the process, Fed created synchronized global inflation/stagflation as almost all major G20 central banks usually follow Fed policy action for currency (USD) and bond yield differential. The late action of the Fed coupled with supply chain issues and policy paralysis in the White House created synchronized elevated sticky core inflation globally (except in China).

Fed increased the repo rate by +500 bps in the last year, whereas core inflation was reduced only by -100 bps, in line with a 2Y bond yield increase of about +150 bps. The market is expecting a rate cut by Fed by almost -100 bps by Dec’23 despite Fed trying to pour cold water on that market expectation. The U.S. paid around 9% of its revenue last year as interest on public debt and can’t afford to increase the same well into double-digit around Japan’s 15%; China and Europe are now paying around 5.5% of revenue as interest on the public debt (deficit spending). Thus the U.S. has no option but to pause soon after a possible hike in June but to also reduce elevated inflation by both monetary and fiscal action.

Bottom line:

Fed may hike +0.25 bps in June for a terminal repo rate of +5.50% and go for pause (not pivot) in July and September to assess the impact of higher rates on inflation and the labor market; if core inflation still doesn’t drop substantially, then Fed has no option but to go for another +25 bps hike in November and December for a terminal repo rate +6.00%.