Dow recovered on the progress of the debt deal; Gold slid

Wall Street Futures, Gold tumbled Wednesday on higher bond yields amid US debt deal uncertainty and hawkish Fed talks/FOMC minutes, indicating at least another +25 bps rate hike in June. But after the US market hour late Wednesday, Nasdaq Future surged on an upbeat report card from AI chip maker Nvidia. On early European Thursday, Dow Future made a low of around 32700 from overnight closing levels around 32900 on the US debt limit political soap opera and also on the ‘winter recession’ in Germany.

European stocks were under pressure of the concern of stagflation/recession/slowing economic activities not only at home but also in China, the largest trading partner of the EU. As a result, European luxury goods makers are under pressure along with commodity producers. Wall Street Futures were also under pressure as global rating agencies are warning about lingering political drama over the debt limit and Fitch even downgraded the US outlook from stable to negative for increasing political squabbling and adverse comments by some US Lawmakers. DBRS Morningstar and Fitch have taken the step of placing the U.S. credit rating under review for a potential downgrade, due to increasing political and policy paralysis, even if the US will eventually increase/suspend the debt limit.

In a statement, DBRS Morningstar expressed that the "Under Review with Negative Implications" status was a reflection of the risk associated with the possibility of Congress failing to timely increase or suspend the debt ceiling. The agency further emphasized that if no action is taken, the US federal government may face challenges in meeting all its financial obligations. Fitch even said: ‘Greater chances that the debt ceiling will not be raised or suspended’.

Risk trade sentiment was also affected as Russia again warned about using tactical nukes and reportedly transferring some nuke arsenal to Belarus. Belarus' President Lukashenko said: “The transfer of non-strategic nuclear weapons from Russia to Belarus has already started”. Subsequently, Gold surged from around 1955 to 1965 after Europe opens.

But Wall Street as well as European index futures were also supported by tech/Nvidia/AI chip makers boost and Dow Future made a session high around 32875 by U.S. opening hour after House Speaker McCarthy downplayed Fitch outlook downgrade for the U.S. and assured a debt deal by the weekend.

Again Dow Future and Gold stumbled after better-than-expected GDP data for Q1 in the 2nd estimate and jobless claims rose less than expected as it may force Fed for not only another rate hike in June, but also in July. Subsequently, Gold made a panic low around 1939, USD/US bond yield surged to a multi-month high, while Dow Future made a multi-month low around 32619; Nasdaq was steady due to Nvidia boost as earnings and revenue beat and the company reported a stronger-than-expected revenue guidance driven by surging AI chip demand.

U.S. Q1CY23 Real GDP Growth Revised Higher to +1.3% from earlier estimate of +1.1% (annualized):

On Thursday, the BEA 2nd estimate data shows the U.S. real GDP for Q1CY23 was revised higher to $20246.40B vs 1st estimate of $20235.90B against Q4CY22 figure $20182.50B (+0.32%) and Q1CY22 figure $19924.10B (+1.62%); i.e. the U.S. economy expanded +0.32% sequentially and +1.62% yearly. The sequential growth of +0.32% is equivalent to an annualized rate of +1.27% (~1.3%) against the 1st estimate of +1.06% (~1.1%). In Q4CY22, the U.S. economy grew at a seasonally adjusted annualized rate of +2.55% (~2.6%).

The updated real GDP estimates in Q1CY23 primarily reflected an upward revision to private inventory investment. The increase in real GDP reflected increases in consumer spending, exports, Federal government spending, state and local government spending, and nonresidential fixed investment that were partly offset by decreases in private inventory investment and residential fixed investment. Imports, which are a subtraction in the calculation of GDP, increased in Q1CY23.

In the 2nd estimate, private inventory investment subtracted -2.1% from the GDP, slightly less than a -2.3% drag in the advance estimate. Also, consumer spending growth accelerated more than expected to 3.8% (vs 3.7% in the advance estimate) despite stubbornly high inflation. Upward revisions were also seen for non-residential fixed investment growth (1.4% vs 0.7%) and public spending (5.2% vs 4.7%). On the other hand, residential fixed investment shrank at a faster pace (-5.4% vs -4.2% in the advance estimate). Net external demand has also contributed positively to the GDP as exports rose more than imports. Despite the upward revision, Q1CY23 real GDP growth remains the weakest since Q2CY22.

U.S. Corporate Profits Sink 6.8% in Q1CY23:

On Thursday, the BEA flash data also shows U.S. corporate profits tumbled -6.8% to $2307B in Q1CY23, the lowest since Q2CY21, lower than market expectations of a -0.9% decrease and following a -2.7% fall in the previous period. It was the largest decrease in corporate profits since Q1CY20 when it slid -7.4%. Net cash flow with inventory valuation adjustment, the internal funds available to corporations for investment, decreased -1.5% to $3099B and undistributed profits slumped -20.6% to $0.652T while net dividends were unchanged at $1.655T.

U.S. debt limit political negotiation continues with some progress:

On late Wednesday/Thursday, there were some reports of optimism on debt limit drama:

·         US House Republican leadership to tell lawmakers they can go home for memorial day weekend, but be prepared to return on short notice in case of a debt limit deal

·         Rep. Jefferies makes demand that the length of spending caps match the length of the debt limit increase. Two years of caps should equal two years increase in debt he says

·         US House Speaker McCarthy says could get a debt agreement in principle this weekend

·         US Treasury says the Fitch warning reinforces the need for a debt limit hike

·         House Rep. Speaker McCarthy: I'm not worried about Fitch ratings watch

·         House Rep. Speaker McCarthy: I have instructed negotiators to work 24 hours a day to get a debt ceiling deal

·         House Rep. Speaker McCarthy: Not everyone will be happy with the debt deal

·         House Rep. Speaker McCarthy: Negotiators have made some progress on the debt ceiling

·         The sides are inching closer in the debt ceiling talks. One source familiar with the negotiations would not rule out the possibility of getting an agreement today. A senior House GOP source told Fox “We still have some things to resolve. We have to see if it’s final, final.” - Fox Reporter Tweets

·         US Senator Lee: I will use procedural tools to impede the debt deal

·         House Rep. Speaker McCarthy: We will take whatever x-date the Treasury Secretary date gives us

·         House Rep. Speaker McCarthy: We will get this done at the end of the day

·         House Rep. Speaker McCarthy: We will get a debt ceiling deal done

·         House Rep. Speaker McCarthy: It's very difficult for Democrats to agree to spend less

·         House Rep. Speaker McCarthy: Biden knows where we are, understands the differences, and will continue to be at the table

·         House Rep. Speaker McCarthy: Any day is possible for a debt ceiling deal but issues remain

·         House Rep. Speaker McCarthy: We made progress on debt-limit talks yesterday

·         House Rep. Speaker McCarthy: I don't know if will have a debt deal today

·         House Rep. Speaker McCarthy: I spoke to US Senate Republican Leader McConnell yesterday

·         House Rep. Speaker McCarthy: We could get a debt deal at any time

·         US Deputy Treasury Sec. Adeyemo: we're making progress in debt ceiling negotiations

·         House Rep. Speaker McCarthy: I take June 1 as the debt ceiling deadline

·         Top GOP negotiator Graves says they don’t have plans to return to the WH on the debt ceiling. “We've made clear that we're willing to meet, anytime, to get this resolved, and I think, you know, we began seeing a little bit of movement yesterday” - Fox Reporter Tweets

·         White House & GOP discuss debt cap lift through 2024 – Punchbowl

·         House Democrats are meeting at noon - Two Sources cited by a WaPo Reporter on Twitter

·         US House Leader Scalise: The issues are narrowing in the debt limit talks - WaPo Reporter Tweets

·         US GOP Rep. Graves: There are no plans for debt-limit negotiators to meet today

·         US Deputy Treasury Sec. Adeyemo: The banking system remains resilient

·         US Representative Hern, Head of largest Republican Caucus: A debt-ceiling deal is likely by tomorrow afternoon

·         McHenry on debt ceiling talks: Nothing's resolved. And everyone wants to think you're going to lock up something. You can't bank anything until you have a complete deal

·         House Dems are on the floor now, speaking against the GOP going on recess over Memorial Day despite the looming debt ceiling. Jeffries to speak soon - Fox Reporter

·         Lawmakers near a deal on energy permitting in the debt ceiling talks – WaPo

·         White House and Republican debt limit proposals differ now by less than $70 bln on discretionary spending – Source

·         Contours of the US debt limit deal take shape, focused primarily on the top-line number – Sources

·         Negotiators are likely to agree on a slimmed-down accord with just a few key numbers – sources

·         Biden administration dusts off contingency plan for payments after debt ceiling deadline – WSJ

·         GOP Rep. McHenry: There is alignment on what we need to work on

·         White House Spokeswoman Jean-Pierre: GOP and the White House teams met virtually at 11:30 AM ET

·         House Dem leadership offered this update to caucus, per 2 sources: No deal yet but predicting votes Tuesday night or Wednesday night (May 30-31) - Politico Reporter Tweets

·         White House: The debt ceiling is not a matter of debate, but the budget remains up for debate

·         White House: Biden's team has had productive debt ceiling talks and discussions are to continue

·         GOP Rep. McHenry: Biden administration's outbound investment proposal requires rigorous scrutiny by the Treasury and thorough oversight by Congress - letter to US Treasury Secretary Yellen

·         GOP Rep. McHenry to Yellen: It's unclear that investment restrictions would be more effective than export controls or sanctions in regulating foreign investment

·         GOP's McHenry: I don't think a deal will be done today. We are not quite in that zone yet

·         Republican Negotiator McHenry: I don't think that a deal on the US debt ceiling will be reached today, but the list of outstanding issues is growing shorter

·         GOP House Rep. McHenry: I'm not pessimistic

·         GOP Debt Negotiator McHenry: The debt deal items list getting shorter

·         Biden: We put forward a proposal to freeze spending for two years

·         Biden: House Rep. Speaker McCarthy's negotiations are about budget outlines

·         Biden: We all agree there will be no default

·         Biden: House Rep. Speaker McCarthy and I have had several productive conversations

·         GOP Rep. Graves: A debt limit deal today will be hard; we are still negotiating

·         White House Communications Director: We are getting closer to a deal on the debt ceiling

·         GOP Debt negotiators give ground on defense spending demands

On late Wednesday, Fed’s Bostic said:

·         Best case scenario is Fed won't consider a rate cut until well into 2024

·         Failing to achieve 2% inflation is more problematic for the economy

·         Expect to see labor-market stress when inflation eases to the target

·         The Fed does not want to be trapped in a specific rate path

·         Fed officials will base rate decisions on data

On Thursday, Fed’s Barkin said:

·         The US is still at the tail end of the pandemic dislocation to the economy

·         Fed rate hikes are also helping reduce demand, as is credit tightening due to bank failures

·         Demand is cooling, in part because it was overstimulated during the pandemic

·         The labor market is quite tight

·         Some businesses are still saying they need to raise prices

·         The Fed is in a test-and-learn situation to determine how slowing demand lowers inflation

·         The places that are most stressed in the CRE space are larger downtown buildings and there is a lot of pain in that space

·         Data on productivity has been moving the wrong way, but much is unknown about COVID impacts on hiring and the labor force

·         The Fed is in a test-and-learn situation to determine how slowing demand lowers inflation

On Thursday, Fed’s Collins said:

·         A pause on rate action would give Fed space to measure the impact

·         The Fed may be at or near the point it can pause rate hikes

·         The Fed is monitoring a wide range of data on the economy's health before the Fed's next move

·         A rate pause gives us space to assess actions to date

·         The US inflation rate is too high and is showing signs of easing

·         I don't see a recession in my baseline outlook

·         The inflation decline has been slower than expected

·         I would not be surprised by a modest increase in unemployment

·         The baseline outlook does not hold for the significant economic downturn

Market wrap:

On Thursday, Dow Future recovered almost +300 points from around 32619 in late-day trading and made a high around 32912 before closing around 32795 on hopes & hypes of an imminent US debt deal and less hawkish talks by Fed’s Collins. Also the US Deputy Treasury Sec. Adeyemo clarified the US will not decouple from China: “We are not decoupling from China.”

On Thursday, Wall Street was boosted by techs, communication services, industrials, real estate, and banks & financials to some extent, while dragged by energy (oil tumbled as Russia downplayed any further OPEC+ cut), utilities, healthcare consumer staples, consumer discretionary and materials. Nasdaq surged +2.55% on Nvidia boost (+25%), the S&P 500 surged +0.85%, while DJ-30 edged down -0.19%.

Conclusion:

Expect a last-minute debt deal/breakthrough by the 26-28th May 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. 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.