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Wall Street Futures were already under stress on lingering uncertainty about the U.S. debt limit hike and the concern that the U.S. may default on its obligation after 1st June (X-date/doomsday). As a result, U.S. bond yield surged. The benchmark 10Y US bond yield surged to almost +3.71%, from +3.28% seen in 1st week of April. Yields on lower-maturity bonds, which are associated with a higher risk of default, have experienced significant increases, with the four-week bill reaching 5.8%, while yields on June 1st T-bills surged above +7% as the U.S. credit card limit is going to exhaust if credit limit not increased further and theoretically/technically, U.S. may even default. Meanwhile, all House Democrats sign a petition to a force debt vote.
On Tuesday, Wall Street got cold feet after a report that the U.S. Treasury Department has asked federal agencies whether they can make pending payments at a later date, as senior Biden admin officials look for new methods to conserve funds and prevent the U.S. from going into any kind of default. Also, USD/US bond yield is getting a boost from hawkish Fed talks and increasing the probability of another +25 bps hike in June.
On Wednesday, House Rep. Speaker McCarthy said (after another day of failed negotiation with Biden):
· I believe we can still reach a debt ceiling deal before June 1
· We're not putting any debt ceiling plan on the US house floor that doesn't spend less than we spent this year
· I have not spoken to Biden since Monday
· Negotiators will get together this morning
· The debt ceiling talks are still productive
· I talked to White House negotiators today
· I'll provide an update on the debt negotiations today
· I think we can make progress today
· I firmly believe we'll be able to get a deal
· We won't put a clean debt ceiling on the floor
· Spending caps and work requirements are Democrat's ideas
· We've offered a lot of concessions
· We can get to yes on the debt deal
· I think we can make progress today
· I have told Biden we won't raise taxes
· We are still far apart on many things
· I'm sending our negotiators down to the White House to try to finish up talks
· This stands by my statement yesterday that people should not be worried about their stocks. It's "a good sign" that the sides are meeting today
· We are in the room right now negotiating, things are going a little better
· The only stumbling block is spending, I will not put a bill on the floor that spends more money this year than last year
· We will agree, I think the President is realizing he has to spend less
· I've always thought we could get a deal in a day
· Negotiations will continue this evening
· I want to make sure we get the right agreement
· Things are better than they were yesterday
· I don't have a set time to meet with the President
On Wednesday, the White House said:
· We will continue to negotiate in good faith to reach a reasonable budget agreement
· Negotiations with GOP lawmakers remain productive
· Millions of jobs would be lost, and recession could follow
· President Biden and House Rep. Speaker McCarthy will speak when the time is right
· President Biden will be wherever he needs to be to a secure deal
· The White House is not coordinating payments with the Treasury
On Wednesday, the U.S. Treasury Secretary Yellen said in a Congressional testimonial hearing:
· Inflation is coming down very meaningfully
· I'm seeing stress in the financial markets, including bill auctions
· Payment prioritization is not operationally feasible
· There will be some obligations we will be unable to pay, post-x-date
· President Biden has offered changes that will result in $1 tln in deficit reduction
· I believe a deal is possible to avoid a debt limit default
· We maintain early June as the debt ceiling default deadline and will update Congress shortly about government finances
· It is hard to be precise about which day resources will run out
· It is highly likely to run out of sufficient cash in early June
· Data suggest the path to avoid a big jump in unemployment
· US Treasury: The operating cash balance as of Tuesday was $76.55 bln vs $68.34 bln on Monday
On Wednesday, Fed’s Waller said:
· There is higher-than-usual uncertainty about credit conditions
· I am concerned inflation won't come down much unless the growth of average hourly wages nears 3%
· The April PCE inflation and May CPI data will be critical
· More loosening of the very tight labor market needs to be seen to help take heat off high inflation
· I am concerned about the lack of progress on inflation
· I do not support stopping rate hikes unless there is clear evidence that inflation is moving down to the 2% target
· The Fed needs to maintain flexibility on the best policy decision for the June meeting
· Prudent risk management may suggest skipping a hike in June, and leaning toward a July hike depending on inflation data and if banking conditions haven't tightened excessively
· I do not expect that data in the next couple of months to make it clear that the terminal interest rate has been reached
· The decision on whether to hike rates or skip hike at the June meeting will depend on data over the next three weeks
· A good inversion is when you think inflation will come down, it suggests the belief that it will
· My current view on the Fed rates unaffected by debt
On Wednesday, some focus of the market was also on FOMC minutes for the May meeting:
· Participants agreed that inflation was unacceptably high, and is declining slower than they had expected
· Some participants noted concerns that the Federal debt limit may not be raised promptly, threatening significant financial system disruptions, tighter financial conditions
· Participants judged that the banking sector stress would likely weigh on economic activity but to an uncertain extent
· Many participants focused on the need to retain optionality after the May meeting
· Fed officials split on support for more hikes
· Fed officials stress data-dependent approach, cuts unlikely
· Fed officials saw timely debt limit increase as essential
· Some participants stressed it was crucial that policy that the statement not signal the likelihood of rate cuts this year or rule out further hikes
· Fed staff continues to forecast a mild recession starting later this year, followed by a modestly-paced recovery
· Several participants said if the economy evolved along the lines of their outlooks, further policy firming might not be needed
· Participants generally agreed that the extent to which further interest rate hikes may be appropriate had become less certain
· Participants discussed their views on the extent to which further policy firming after the current meeting may be appropriate.
· Participants generally expressed uncertainty about how much more policy tightening may be appropriate
· Many participants focused on the need to retain optionality after this meeting
· Some participants commented that, based on their expectations that progress in returning inflation to 2 percent could continue to be unacceptably slow, additional policy firming would likely be warranted at future meetings
· In light of the prominent risks to the Committee's objectives concerning both maximum employment and price stability, participants generally noted the importance of closely monitoring incoming information and its implications for the economic outlook
· Participants noted that risks associated with the recent banking stress had led them to raise their already high assessment of uncertainty around their economic outlooks
· Participants judged that risks to the outlook for economic activity were weighted to the downside, although a few noted the risks were two sided
· On the debt ceiling:
· Many participants mentioned that it is essential that the debt limit be raised in a timely manner to avoid the risk of severely adverse dislocations in the financial system and the broader economy. A few participants noted the importance of orderly functioning of the market for U.S. Treasury securities or stressed the importance of the appropriate authorities continuing to address issues related to the resilience of the market. A number of participants emphasized that the Federal Reserve should maintain readiness to use its liquidity tools, as well as its micro-prudential and macro-prudential regulatory and supervisory tools, to mitigate future financial stability risks
· On the impact of policy:
· Fed staff reiterate forecast for a “mild recession starting later this year, followed by a moderately paced recovery”
· On the banking crisis:
· In terms of financial-sector leverage, going into the period of recent bank stress, banks of all sizes appeared strong, with substantial loss-absorbing capacity as measured by regulatory capital ratios well above levels that prevailed before the Great Recession. However, the ratio of tangible common equity to total tangible assets at banks—excluding global systemically important banks—had fallen sharply in recent quarters, partly because of a substantial drop in the value of securities held in their portfolios
· The majority of the banking system had been able to effectively manage this interest rate risk exposure. However, the failure of three banks resulting from poor interest rate risk and liquidity risk management put stress on some additional banks. For the nonbank sector, leverage at large hedge funds remained somewhat elevated in the third quarter of 2022, and more recent data from the Senior Credit Officer Opinion Survey on Dealer Financing Terms suggested this fact had not changed
· On tightening credit conditions:
· Several participants remarked that tighter credit conditions may not put much downward pressure on inflation, in part because lower credit availability could restrain aggregate supply as well as aggregate demand
On Wednesday, Dow Future made a panic low around 32806 on US debt limit uncertainty. But it got some boost in the last hour of trading and recovered to almost 33000 levels after the White House assured Biden will do whatever is required for a deal and the White House is not coordinating with Treasury for any payment priority/control. Also, Treasury reported $76.55B Tuesday vs $68.34B on Monday. But eventually, Dow Future slips again and closed around 32888, around 7-week lows to close more than 250 points lower, while the S&P 500 and the Nasdaq slid 0.7% and 0.6% respectively amid lingering US debt limit suspense and political war of attrition. Overall, FOMC minutes have no impact on the market today, but it indicated at least another rate hike in June. Fed’s Waller also indicated the same.
Citigroup slumped as the bank announced plans to spin off its Mexico business and Biotech Company Moderna tumbled. But after the US market hour, Nasdaq Future surged on an upbeat report card from AI chip maker Nvidia. Also, Kohl's and Abercrombie & Fitch jumped on an upbeat report card. On Wednesday, apart from energy (Chevron upgrade boost), all the rest 10-SPX 500 sectors were in the red.
Expect a last-minute debt deal/breakthrough by the 25-28th after the 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. Putin and Xi will have the last laugh!
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 may go for another +25 bps hike in June for a terminal repo rate of +5.50%, while ECB may further hike by +25 bps each in June and July. Moreover, if core inflation does not dip below +5.00% in the Eurozone by August, then ECB may have no option but to go for a further +25 bps rate hike each in September, October, and December for a terminal repo/MLF rate +5.25%.
ECB wasted at least 3 months to match Fed’s rate action and thus now scrambling to match as a consistently weaker EURUSD will also result in higher imported inflation, everything being equal. Europe may be the biggest loser of the Russia-Ukraine/U.S./NATO war/proxy war as it’s an importer of both food and fuel apart from various other commodities. The high cost of living crisis in Europe may invite bigger social and political unrest in the coming days if inflation does not come under control in the coming days.
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. Putin is winning the financial war against Biden!
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