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Dow surged on hopes of US debt deal passage and Fed pause

Dow surged on hopes of US debt deal passage and Fed pause

calendar 01/06/2023 - 21:42 UTC

Wall Street Futures recovered Wednesday on the progress of Congressional passage of the US debt bill and hops of a Fed pause in June. Late Wednesday, the U.S. House, where opposition Republicans are in majority now (after Nov’22 mid-term election), passed the debt bill (Budget agreement) by an overwhelming majority (314-117) to forward it to Senate. Democrats supported the bill 165-46, while Republicans supported it by a vote of 149-71. Democrats (Biden & Co) supported the bill (Fiscal Responsibility Act’2023) 165-46, while Republicans (McCarthy & Co) supported it by a vote of 149-71. The bill has now been sent to the Senate, where it is expected to be passed by Friday. U.S. President Biden issued an official statement soon after the passage of the debt bill/budget agreement passage by the House.

Statement from President Joe Biden on House Passage of the Bipartisan Budget Agreement:

Tonight, the House took a critical step forward to prevent a first-ever default and protect our country’s hard-earned and historic economic recovery. This budget agreement is a bipartisan compromise. Neither side got everything it wanted. That’s the responsibility of governing. I want to thank Speaker McCarthy and his team for negotiating in good faith, as well as Leader Jeffries for his leadership.

This agreement is good news for the American people and the American economy. It protects key priorities and accomplishments from the past two years, including historic investments that are creating good jobs across the country. And, it honors my commitment to safeguard Americans’ health care and protect Social Security, Medicare, and Medicaid. It protects critical programs that millions of hardworking families, students, and veterans count on.

I have been clear that the only path forward is a bipartisan compromise that can earn the support of both parties. This agreement meets that test. I urge the Senate to pass it as quickly as possible so that I can sign it into law, and our country can continue building the strongest economy in the world.”

The U.S. House Speaker McCarthy said: "Passing the Fiscal Responsibility Act is a crucial first step for putting America back on track. It does what is responsible for our children, what is possible in divided government, and what is required by our principles and promises."

The U.S. Senate Majority Leader Schumer (Democrat) warned before the House vote: "The consequences of slipping past the deadline would reverberate across the world and take years to recover from. Remember, a default would almost certainly trigger another recession, send costs soaring, and kill millions of jobs -- hardworking people thrown out of work through no fault of their own.

The present budget and debt agreement suspends the debt ceiling until Dec’24, while the proposed spending cuts for FY: 24-25 may result in a lowering of the Federal budget deficit by around $1.5T (as per CBO estimate). Now the budget/debt agreement needs at least 60 votes of the 100-member Senate, where Democrats now have 51 senators against 49 Republicans. Out of 51 Democrat Senators, Sanders and Merkley, two leftist independents Democrat supporters may not support the budget agreement. Another leftist Democrat Senator Warren may also raise her objection. But Senate Minority Leader McConnell (Republicans) is expected to bring in at least 12 Republican votes in favor of the debt/budget bill for the ultimate passage without causing further political soap opera.

On Wednesday, Sanders tweeted and issued a statement:I cannot, in good conscience, vote for the debt ceiling deal.”

“Let’s be clear. The original debt ceiling legislation that Republicans passed in the House would have, over 10 years, made savage cuts to programs that working families, the children, the sick, the elderly, and the poor desperately need.

The best thing to be said about the current deal on the debt ceiling is that it could have been much worse. Instead of making massive cuts to health care, education, childcare, nutrition assistance, and other vital programs over the next decade, this bill proposes to make modest cuts to these programs over 2 years. This bill will also prevent an economic catastrophe by extending the debt ceiling until January 1, 2025 – when we will have to go through with this absurd process once again.

Having said that, I cannot vote for this bill.

At a time of massive wealth and income inequality, I cannot, in good conscience, vote for a bill that takes vital nutrition assistance away from women, infants, children, and seniors, while refusing to ask billionaires who have never had it so good to pay a penny more in taxes. I cannot, in good conscience, vote for a bill that makes it harder for working families to afford the outrageously high price of childcare, housing, and health care while making it easier for the wealthiest people and most profitable corporations in America to cheat on their taxes.

At a time when climate change is, by far, the most existential threat facing our country and the entire world I cannot, in good conscience, vote for a bill that makes it easier for fossil fuel companies to pollute and destroy the planet by fast-tracking the disastrous Mountain Valley Pipeline. When the future of the world is literally at stake we must have the courage to stand up to the fossil fuel industry and tell them, and the politicians they sponsor, that the future of the planet is more important than their short-term profits.

At a time when we spend more on the military than the next ten nations combined, I cannot, in good conscience, vote for a bill that increases funding for the bloated Pentagon and large defense contractors that continue to make huge profits by fleecing American taxpayers with impunity. Let me remind my colleagues that the Pentagon is the only federal agency that cannot pass an independent audit or account for trillions of dollars in spending.

At a time when the pharmaceutical industry is charging the American people, by far, the highest prices in the world for prescription drugs I cannot, in good conscience, vote for a bill that does nothing to take on the greed of the big drug companies that are bankrupting Medicare and cancer patients while spending tens of billions of dollars on stock buybacks and dividends.

At a time when over 45 million Americans are drowning in student debt, I cannot, in good conscience, vote for a bill that eliminates the moratorium on student loan payments that has been a lifeline to millions of working families during the pandemic.

Deficit reduction cannot just be about cutting programs those working families, the children, the sick, the elderly, and the poor depend upon. It must be about demanding that the billionaire class and profitable corporations pay their fair share of taxes, reining in out-of-control military spending, reducing the price of prescription drugs, and ending billions of dollars in corporate welfare that goes to the fossil fuel industry and other corporate interests.

The fact of the matter is that this bill is unnecessary. The President has the authority and the ability to eliminate the debt ceiling today by invoking the 14th Amendment. I look forward to the day when he exercises this authority and puts an end, once and for all, to the outrageous actions of the extreme right wing to hold our entire economy hostage to get what they want.”

Overall, the final passage of the debt/budget bill in its present form may be negative for oil as it would pave the way for more supply. But the bill is positive for defense (higher budget allocations), pharma (less price control) and overall corporate America (no tax hike), but the overall cut in government spending is also negative. Thus the present budget agreement is expected to add only around +0.02% of real GDP; i.e. almost neutral.

On early Thursday, Dow Future made a panic low around 32737 from overnight closing levels of 33000 as political uncertainty over the passage of the debt/budget agreement in the Senate is not over yet. Also, ADP Private Payroll data came hotter than expected and jobless claims rise less than expected, which may prevent Fed from the much-expected June pause. But the Challenger job-cut report also came hotter than expected. Now all focus would be Friday’s US job report.

On Thursday, Fed’s Harker said:

·         Bank credit tightening will have a modest effect, maybe the equivalent of a 25 bps rate hike

·         It's time to hit the stop meeting for at least one meeting

·         We have a reasonably wide path to avoiding a recession altogether

·         I don't think we'll have a recession this year

·         If inflation started coming down unexpectedly fast, then we could cut rates. That is not my forecast

·         If we saw an unexpected and significant deterioration in the job market, I would worry

·         Let's skip this one, and see how it goes

·         Reports today from retailers show people aren't spending like they used to

·         I think we should at least skip raising rates in June

·         In the short run, it seems we have resolved the debt limit crisis

·         We don't have to keep moving rates up

·         We are at the point, or close to the point, where we can sit on rates for a while

·         I favor looking beyond headline inflation numbers

·         Low-wage workers are taking the brunt of high inflation and will take the brunt of higher unemployment

·         Absent a black swan event, we see inflation marching down to 2% in the next couple of years

·         I am starting to see the effects of rate hikes on wages and prices

·         Upside risks to inflation include another black swan

·         Revisions on wage data show a cooling

·         We're close to the place where we can hold rates in place

·         We are on a downward path for inflation, but it is frustratingly stubborn

·         I see promising signs that the Fed's rate hikes are working

·         Disinflation is disappointingly slow, inflation is still way above the Fed's target

·         I am closely monitoring data to assess whether additional policy tightening will be needed

·         I expect inflation to fall to around 3.5% this year, 2.5% next year, and reach Fed's 2% target in 2025

·         I project 2023 GDP growth below 1% and the unemployment rate to rise to 4.4%

·         The US central bank is close to the point where it can hold interest rates in place

·         It will take some time to evaluate how recent events impact economic activity and inflation

On Thursday, Fed’s Bullard said in an academic presentation: Is Monetary Policy Sufficiently Restrictive?

“Since mid-2021, inflation has been running well above the 2% target set by the Federal Open Market Committee (FOMC). To put downward pressure on inflation, in March 2022 the FOMC began a series of increases to the federal funds rate (i.e., the policy rate), with the aim of making monetary policy “sufficiently restrictive” to return inflation to 2% over time, as noted in several of the committee’s post-meeting statements since November.

The current range for the federal funds rate stands at 5%-5.25% following the increase at the May FOMC meeting. How can we know if the policy rate is at a level that could be considered sufficiently restrictive? In a recent presentation, I used monetary policy rules to examine this question.

Monetary Policy Rules as a Guidepost

Monetary policy rules provide explicit recommendations for the level of the policy rate given macroeconomic conditions, which then serve as a guidepost for where policy should be. One of the most famous monetary policy rules is the “Taylor rule,” which was developed by John Taylor of Stanford University and has been widely accepted in monetary policy discussions over the last 30 years. Versions of his rule (“Taylor-type rules”) have been tested in commonly used macroeconomic models and have been argued to characterize close-to-optimal monetary policy.

A Taylor-type rule requires:

A value for the short-term real rate of interest that would prevail if the economic output was at potential and the inflation rate was at target

A measure of the size of the current inflation gap (i.e., deviation of inflation from target)

A measure of how strongly the policymaker should react to the inflation gap

A value for the size of the output gap (i.e., deviation of output from potential output)

In my presentation, I ignored the output gap for recent periods. The FOMC has stated that “policy decisions must be informed by assessments of the shortfalls of employment from its maximum level.” Since unemployment is not currently above its longer-run natural rate, it isn’t necessary to factor in an output gap term.

An Assessment of a Sufficiently Restrictive Zone

My approach was to look at a Taylor-type monetary policy rule with generous assumptions, the goal being to provide a minimum recommended level of the policy rate given current macroeconomic conditions. The generous assumptions tend to recommend a lower policy rate. I also looked at a Taylor-type rule with less generous assumptions, the goal being to offer an upper bound for the recommended policy rate. The area between the lower and upper bounds can be considered the “sufficiently restrictive zone.”

The table below shows the assumptions I used for these two versions of the Taylor-type rule.

So, can the current policy rate be considered sufficiently restrictive?

The figure below shows a zone of realistic values for a sufficiently restrictive level of the policy rate from 2019 through the present. The zone’s lower bound is represented by the Taylor-type rule with generous assumptions, while its upper bound is represented by the Taylor-type rule with less generous assumptions. As seen in the figure, the zone can move in reaction to incoming data; for instance, it started to move up in 2021 as inflation began exceeding 2%.

According to this analysis, monetary policy was about right shortly before the COVID-19 pandemic, as the actual policy rate was within the zone. During the pandemic, the policy rate recommended by the Taylor-type rules went to zero along with the actual policy rate. However, the policy rate was below the zone in 2022, suggesting that monetary policy was behind the curve at that point. But since the FOMC has raised the policy rate aggressively during 2022 and into 2023, monetary policy is now at the low end of what is arguably sufficiently restrictive given current macroeconomic conditions.

Monetary Policy in Better Position Today

Monetary policy is in much better shape today with the policy rate at a more appropriate level than it was a year ago, according to this analysis. But where within the sufficiently restrictive zone should the policy rate be? And are there other factors to consider (e.g., financial stability)? Such assessments could be reflected in judgments by the FOMC going forward.

While both headline and core PCE inflation have declined from their peaks in 2022, they remain too high. An encouraging sign that inflation will decline to 2% comes from market-based inflation expectations, which had moved higher in the last two years but have now returned to levels consistent with the 2% inflation target. The prospects for continued disinflation are good but not guaranteed, and continued vigilance is required.”

Conclusion:

The market was expecting some hawkish comments by Fed’s Bullard ahead of the Fed blackout period as he advocated at least one more hike in June for a +5.50% repo rate, which would be at the middle levels of his restrictive rate zone (5.00-6.00%). But on Thursday, it seems that Bullard was satisfied with present levels of repo rate at +5.25% and may not object much to a pause on 14th June in line with Harker, Jefferson and even Powell. And the market is now discounting around 75% probability of a Fed hold in June, while any Fed speakers are not jawboning hard to negate that just ahead of the blackout period. Fed never surprised the market in its rate action and thus if Friday’s May job report comes as goldilocks, not a blockbuster, and the May core inflation report (to be published on 13th June, just a day ahead of Fed’s MPC day) does not surge further, Fed may go for a pause on 14th June, but may also jawbone for another one/two hikes in September and December.

Market wrap:

On Thursday, Wall Street Futures surged on hopes of an imminent passage of the U.S. debt/budget deal and Fed pause in June (while it may not be a pivot). Dow surged +0.47% (+153 points), while the S&P 500 gained nearly 1%  (hit a 40-week high) and the Nasdaq jumped 1.3%, also touching its 40-week level high during the session.

Fresh ISM data showed manufacturing activity contracted for the 5th consecutive month and price pressures eased significantly; reinforcing bets the Fed will pause the tightening cycle this month. As a result, Treasury yields fell and tech shares got a boost. On the other hand, Salesforce plunged after the company reported higher capex than expected.

On Thursday, Wall Street was boosted by techs, industrials, materials, energy (oil recovered on a bullish EIA inventory report and OPEC+ lower output for May); consumer discretionary; communication services; banks & financials; healthcare; and real estate to some extent, while dragged by utilities (lower bond yields) and consumer staples.

Bottom line:

If Fed indeed goes for a pause in June and the US debt deal becomes law by 5th June, expect a risk-on rally and Dow Future may scale 34380 levels soon from around 33150 currently; 32500-400 is now a vital support zone (technically).

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