Dow wobbled on debt deal suspense and hawkish Fed talks

Wall Street Futures slumped Friday despite less hawkish Powell talks on lingering political soap opera over U.S. debt limit negotiations; Gold recovered. On Sunday, U.S. President Biden and House Majority Leader McCarthy had a brief telephonic conversation after debt deal talks between the White House (Democrats) and House Republicans paused Friday on lack of real progress as Biden was preoccupied in Japan G7 meeting. Democrats said debt discussions are going in the wrong direction.

On late Sunday, U.S. President Biden said:

·         Biden asked if he was worried about the debt talks: Not at all

·         I still believe we will be able to avoid a default

·         I'm not going to ease China's sanctions

·         I have made clear I'm not prepared to trade certain items with China because of concern China would build weapons of mass destruction

·         we are maintaining the 'One China policy

·         I will speak to House Rep. Speaker McCarthy during my flight back to the US

·         I won't agree to a deal that protects excess payments to the pharma industry

·         I won't agree to a proposal for a tax break for the oil industry

·         Much of what the Republicans have suggested is unacceptable

·         I have done my part for debt talks with a proposal that cuts spending

·         I believe I do have the authority to use the 14th Amendment

·         I’m not going to agree to a deal that protects wealthy tax cheats and crypto traders while putting food assistants at risk

On late Sunday, House Rep. Speaker McCarthy/other GOP leaders/negotiators said:

·         I don't expect progress until Biden returns

·         The White House has moved backward from yesterday

·         We discussed various timelines for debt limit

·         There are some areas of common ground in debt negotiations

·         It seems Biden wants to default more than wanting a deal

·         We won't raise taxes

·         Biden proposed spending billions more next year

·         Debt discussions have not discussed extending Trump's tax cuts

·         I think markets will take a deal as a real positive

·         Republican negotiators include Representatives Graves and McHenry

·         The Senate may not need the full week I expected it to pass a debt ceiling agreement

·         The call with Biden included a productive discussion of possible solutions

·         We don't have an agreement yet, and time is of the essence

·         I didn't discuss the 14th Amendment with Biden

·         I told Biden spending must be lowered

·         Negotiators will meet later on Sunday at the Capitol

·         Biden and I will meet Monday

·         It was a productive phone call with Biden

·         We discussed various timelines for debt limit

·         There are some areas of common ground in debt negotiations

·         I'm pessimistic about the current state of negotiations- House GOP McHenry

·         There are no plans for debt negotiators to meet at this time- House GOP McHenry

·         We need a multi-year spending cap in any debt deal- GOP Rep. Graves

·         There has been a lot of progress in understanding each side’s red lines and positions- GOP Rep. Graves

·         Spending baseline is the foundation of debt discussions- GOP Rep. Graves

·         There are no plans for debt negotiators to meet at this time- House GOP McHenry

On Monday, House Rep. Speaker McCarthy/other GOP leaders/negotiators said:

·         It's very hard to get them off that spending spree that they're addicted to

·         We will continue working, not at a deal

·         The negotiator's meeting was productive this morning

·         We don't have a deal

·         Thinks we can make it all happen by the debt deadline

·         Nothing has been agreed to in negotiations with Biden on the US debt ceiling

·         We can get a deal tonight, or we can get a deal tomorrow

·         Debt ceiling talks are at a sensitive point

·         I believe that the debt ceiling package that is being negotiated now would be acceptable to a majority of house republicans

·         I think we can make it all happen by the debt deadline

·         I believe that the debt ceiling package that is being negotiated now would be acceptable to a majority of house republicans

·         Last night's debt limit talks were productive- US GOP Rep. McHenry

·         Obstacles to the deal but people are working in good faith- US GOP Rep. McHenry

·         There is still not an agreement on major items- US GOP Rep. McHenry

·         No other debt ceiling talks planned before Biden-McCarthy meeting later Monday- US GOP Rep. McHenry

·         There’s still no agreement on major items. I don’t think there’s any interest in delaying these difficult conversations- US GOP Rep. McHenry

·         I'm concerned about getting a deal that can pass the House, and the Senate, and be signed by the President. It's a complicated piece of math, it is- US GOP Rep. McHenry

·         There’s still no agreement on major items---I don’t think there’s any interest in delaying these difficult conversations- US GOP Rep. McHenry

A White House Official said Monday:

·         House Rep. Speaker McCarthy's team last week moved in a more partisan direction, and Biden continues to look for a bipartisan solution to the debt ceiling.

·         Biden admin opposes the measure to block student debt relief

·         House Rep. Speaker McCarthy's team last week moved in a more partisan direction, Biden continues to look for a bipartisan solution to the debt ceiling

·         White House Official: Any debt ceiling solution must be able to secure democratic votes, not just the House Freedom Caucus.

On Sunday, the U.S. Treasury Secretary Yellen again warned:

·         If the debt ceiling isn't raised, there will be some bills that will have to go unpaid

·         There will be hard choices to make if the debt ceiling isn't increased

·         Legal uncertainty and tight time frame complicate the use of the 14th  Amendment

·         There are revenue suggestions that would make the tax code fairer

·         GOP proposals to reduce IRS funds are greatly concerning

·         June deadline is a hard deadline for debt limit

·         The early June deadline for the debt limit still holds

·         The odds of reaching June 15th when more tax receipts due are is quite low before the government runs out of money

·         Reaffirms June 1 as the ‘hard deadline’ to raise the debt ceiling

·         It is now highly likely cash will run out by early June

On late Sunday, Fed’s Kashkari said:

·         I could support holding interest rates steady at the Fed’s next meeting

·         I would object to any kind of declaration that we’re done lifting rates

·         It's a close call on whether to raise or pause in June

·         We can't protect the economy from a debt default

·         It may be that we have to go north of 6%, but it's not clear

·         Services inflation seems pretty darn entrenched

·         For me, it's a close call on the June meeting on whether to hike or pause

·         I'm not seeing proof yet that banking stress is doing our work for us on inflation

·         The Fed has to keep going on combating inflation

·         I'm seeing the very little imprint of banking problems in the Minneapolis Fed district

·         Significantly more bank capital will increase resilience

On Monday, Fed’s Bullard said:

·         The Fed will have to go higher on the policy rate, perhaps 50bps more hiking, this year; I am expecting two more rate hikes

·         For me, it's a close call on the June meeting on whether to hike or pause

·         This year, I am expecting two more rate hikes

·         I want to fight inflation while the labour market is strong

·         We will have to move rates higher to tame inflation

·         Markets are ratcheting up expectations for inflation

·         The SEP median of 5.1% was based on slow growth and inflation improvements that have not occurred

·         The economy is probably growing at or a bit below the trend

·         US recession probabilities are overstated

·         The base case remains relatively slow growth for the rest of this year and into 2024 and recession probabilities are overstated

·         A debt default would lead to higher US borrowing costs

·         I'm not anticipating changes to QT any time soon

·         The US decoupling from China is the major issue currently

·         Households are still flush and we will continue to support consumer spending

·         If inflation is not controlled the Fed will have to do a lot more and should err on the side of doing more

·         Inflation is staying too high, which is one reason for more hikes

·         The core measures of inflation have not changed much in the recent months

·         The labor market slowing some but that doesn't mean a recession

On Monday, Fed’s Daly said:

·         Prudent to refrain from commenting on Fed policy action

·         FOMC deciding meeting by meeting is the more prudent path

·         I don't know how deep and long credit tightening will be

·         We should be mindful that policy lags could show up at any time

·         The Fed must be on the watch for a slowing economy

·         It is hard to figure out what is slowing the US economy right now

·         Tighter credit conditions may be akin to one to two rate hikes

·         The Fed must be very data-dependent right now, still lots of data to get before June FOMC

·         I want to see an ongoing slowing in super-core inflation

·         Banking stresses have calmed and banks are in solid shape, firms pulling back on lending

·         I want to see if policy tightening is affecting the economy

·         I am focused on the whole dashboard of incoming data

·         I expect house price inflation to come down through year-end

·         It seems completely reasonable to see the unemployment go above 4%

·         It would be a historical anomaly to get 2% inflation with sub-4 % unemployment

·         It's not surprising to see some increase in credit troubles for some Americans

·         Real wage growth for most Americans has been overtaken by inflation

·         Fed forecasts are only as good as the day they are printed

·         I see some indications of slowing in an otherwise strong job market

·         The balance sheet drawdown is working effectively

·         The Fed can separate financial stability tools from monetary policy

·         Global tightening hasn't slowed growth as much as feared

On Monday, Fed’s Barkin said:

·         I am still looking to be convinced that inflation is in a steady decline

·         I will not prejudge the June meeting outcome

·         The Fed has done a lot of tightening, and policy acts with a lag

·         I am comfortable waiting a little bit to see how the economy plays out

·         The Fed has had a lot of tightening over the past year, I don't want to presuppose what any slowdown will look like

·         The recent use of a discount window is a sign of strength and a sign a bank has access to liquidity

·         If Congress did authorize a CBDC the Fed would have to "think hard" about its design

On Monday, Fed’s Bostic said:

·         The Fed has had a lot of tightening over the past year; I don't want to presuppose what any slowdown will look like.

·         Businesses could have a separate FDIC deposit threshold

·         The FDIC deposit insurance thresholds are set for families and are not structured to meet all use cases

·         The question that SVB raises is whether the Fed could use big data algorithms and approaches to identify material risks

·         AI technology could be helpful to bank supervision

·         SVB collapse shows that Fed processes and policies will have to change

·         We may need Fed liquidity to be more accessible and nimble

·         There would be operational challenges to a "24-7" opening of the Fed's discount window

·         SVB's downfall shows that the Fed processes and policies will have to change to become on-demand as banks need them

·         A CBDC could create uncertainty on Fed policy transmission

·         Issues like bank intermediation risks would have to be accounted for in any CBDC

On Monday, the latest Fed surveys on the Economic Well-Being of U.S. Households in 2022 report said:

·         Higher prices have negatively affected most households

·         63% of respondents said they would cover a $400 emergency expense with cash, down from a record-high 68% in 2021

·         73% of respondents said they were doing at least okay financially in 2022 vs 78% in 2021

·         Share of those saying they were worse off increased to 35%, the highest since the question was first asked in 2014

·         More workers received and inquired about a pay increase or promotion in 2022 vs 2021

·         1/3rd of households cited inflation as their main financial challenge

Market wrap:

On Monday, Wall Street Futures wobbled on hopes & hopes of a U.S. debt deal. The Dow Jones closed 140 points lower on Monday, while the S&P finished slightly in the green and the Nasdaq added 0.5%. Hours before Monday’s 5.30 PM scheduled meeting between President Biden and House Speaker McCarthy.

Among stocks, shares of Micron Technology tumbled after China banned some Chinese tech manufacturers from using the company's chips. On Sunday, China banned Micron as a supplier to big Chinese firms, citing national security and product flaws in its cybersecurity review. But the overall impact was negligible as Micron estimated the impact of the China ban to be low to high single digits. Meanwhile, Meta was fined €1.3B for EU privacy violations over data transfers to the U.S. Apple slumped after Loop Capital downgraded its stock to hold from buy.

Wall Street Futures stumbled after ultra-hawkish talks by Fed’s Bullard as he advocated for another 50 bps hike in 2023 and almost confirmed a +25 bps hike on 14th June; Dow Future crumbled almost -200 points from around 33585 to 33374. But Dow Future further stumbled almost -100 points to 33273 after an initial report of a large explosion near The Pentagon complex in Washington DC. But Dow Future soon recovered almost +200 points to around 33466 after the original Tweet on the Pentagon explosion has been removed from the feed, and the Pentagon clarified no such explosion.

Conclusion:

Expect a last-minute debt deal/breakthrough by late Monday after the Biden-McCarthy meeting after the war of attrition in line with respective political compulsions. 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.

Bottom line:

The market is now almost sure of a debt limit deal by Sunday (21st May) or by next Sunday (28th May)-just before the so-called ‘dooms day’ (30th May). Whatever may be the narrative, technically Dow Future now has to sustain above 33575 for a further rally to 33650/750-850/34375; otherwise sustaining below 33525, Dow Future may again fall to 33150-32950, and sustaining below 32950 may further fall to 32570 (in case of further uncertainty over debt limit).