Wall Street recovered on less hawkish Fed talks; Gold surged

Wall Street Futures stumbled Tuesday on U.S. debt/budget deal passage suspense in Congress. On early European Wednesday, Dow Future made a session low around 32910 from an overnight close of 33100, but soon recovered and made a session high around 33066 in hopes of an imminent passage of the debt deal after it was cleared by the House Rules Committee late Tuesday by razor-thin 7-6 majority.

But Dow Future again stumbled early U.S. session after JOLTS job opening data came hotter than expected, which may keep Fed for not only a hike in June but also another 1/2 hikes in H2CY23; subsequently, Dow Future made a panic low around 32794. Again Dow Future recovered almost +250 points and made a high around 33045 before closing around 32955 as Fed’s Jefferson and Harker batted for a pause in June and House Speaker McCarthy said the debt deal may pass the Senate by Thursday or Friday. After less hawkish coordinated Fed talks Wednesday, the market is now indicating only around 32% probability of a Fed hike on 14th June against 72% prior (just ahead of the Fed blackout period).

Now the U.S. House is expected to vote on the debt bill late Wednesday and if passed, then it will move to Senate, where it’s expected to pass by Friday for Biden’s desk (final signature). After the debt/budget agreement bill turns into law by legislative action, the U.S. will have no upper limit of talking further debt till at least Dec’24, and the Treasury will be able to issue more debt to fund Uncle Sam’s deficit spending. 

And creditors including China, Japan, and Saudi Arabia are also happy to provide credit to the world’s largest economy/consumer because the U.S. is also World’s most trusted and qualified borrower nation, with an implacable track record. Although, the U.S. is now paying almost 9.5% of its revenue as interest on public debt, almost double that of the EU and China (5.5%); Japan pays around 15%. Thus there is sufficient fiscal space for the U.S. to fund its deficit spending.

Also, exporter nations like China and Japan having a significant merchandise trade surplus with the U.S., like to keep their USD earnings in US TSY, the world’s safest debt for a risk-free return virtually for a lifetime. Even if the U.S. prints additional USD to pay creditors, no one bothers as the world always needs USD as a trade funding currency due to the status of the World’s reserve currency. The U.S. is taking external debt in its currency (USD), which is a great advantage unlike other nations. But most of the U.S. public debt lies with DIIs (domestic institutional investors like banks & financials) and eventually by the Fed, which is also the biggest beneficiary of interest being paid by the Treasury (on debt).

In any way, such debt limit hike/extension is also a common practice for almost all the major economies including India. But in the U.S., every Lawmaker, especially Senator has immense legislative & political power and may cause political & policy paralysis often as per their whims & fancies (domestic political compulsion). For example, in India, PM Modi has the last word for an absolute majority and no ruling/opposition MP (LS/RS) has any scope to oppose any legislative move. But, the Biden admin is now a minority government after Nov’22 mid-term election, losing the House to Republicans (opposition). Thus, Biden is obliged to compromise with the opposition after two years of trifecta and the same story goes on for the Republicans also.

The U.S. system of mid-term elections just after 2 years of Presidential election is often causing political & policy paralysis. This brings U.S. politicians to focus more on external politics like the anti-China/Russia stands to gain in the domestic election next time. Democrats usually go for higher fiscal stimulus and higher taxes on the rich, while Republicans prefer tax cuts and lower fiscal stimulus (deficit spending), often unfunded. This along with increasing social security spending and unfavorable demography, the public debt level of the U.S. is increasing more than the nominal GDP growth, which is not a good sign.

On Wednesday, JOLTS (Job Openings and Labor Turnover Summary) data shows the number of job vacancies in the U.S. increased to 10103K in April from 9745K in February (almost at a 2Y low), and higher than the market expectations of 9375K. In April, the ratio of the number of job openings and unemployed persons again jumped to 1.8 from 1.6 in March against the pre-COVID ratio of around 1.25. The U.S. economy is now suffering from an acute shortage of labor force due to various structural as well as cyclical issues including unfavorable demography, shrinkage of workforce after COVID, early retirements, legal immigration issues, lack of properly skilled workers, outsourcing, and also increasing number of multiple job holders. Fed is now looking for at least a 1.50 ratio of job openings/unemployed persons as a sign of the labor market cooling.

In April, job openings saw significant increases in several industries, including retail trade (+209K); health care and social assistance (+185K); transportation, warehousing, and utilities (+154K). Fed closely watches JOLTS job opening data as an advance indicator of the health of the labor market. As the April JOLTS job opening data came hotter than expected, Wall Street Futures, Gold slipped, while USD surged as Fed may go for another +25 bps hike not only in June but May also twice more in H2CY23 for a terminal rate around +6.00%.

But Wall Street soon recovered mid-Wednesday on less hawkish Fed talks and upbeat comments (bytes) by US Lawmakers on debt deal passage:

·         GOP Rep. McHenry: Debt ceiling bill should pass on Wednesday

·         GOP Rep. McHenry: We have the votes to pass a debt-limit bill today

·         House Rep. Speaker McCarthy: Debt ceiling bill will become law

·         Scalise on Fox Business on debt ceiling bill: It’ll pass tonight...Spkr McCarthy did a really good job at getting President Biden to the table. Biden was insistent he was not going to negotiate work requirements was a red line that the White House would not give on - Fox Reporter Tweets

·         US Senate Majority Leader Schumer: Once the debt ceiling bill reaches the Senate, will bring it to the floor as soon as possible

·         US House Democratic Leader Jeffries: I will support the debt ceiling bill

·         US Senate Republican Leader McConnell: I will support the debt ceiling bill when it reaches the Senate

·         Biden: I hope Congress will have acted by the time I land in Colorado later today

·         Biden: We're going to deal with the debt ceiling, things are going as planned

·         US Republican Senator Paul: I will not employ parliamentary procedures to delay the Senate vote on the debt ceiling bill

·         US Senate Republican Leader McConnell: I anticipate the debt ceiling bill will pass the House and come to the Senate as soon as Thursday

·         Senate GOP Leader McConnell: We anticipate the debt ceiling bill passing

·         US Senate Republican Leader McConnell: I hope the Senate will finish the debt ceiling bill on Thursday or Friday

·         White House: President Biden expects the debt ceiling bill at his desk by June 5th

·         White House: President Biden will have a statement Wednesday evening on the debt ceiling

·         White House: We believe the debt ceiling bill is going to happen

·         Treasury cash pile shrank to $37.4 bln on May 30, the least since 2017

·         The US House approves the measure to begin the one-hour debate on the debt ceiling bill ahead of an evening vote on passage

·         The House has voted to pass the debate rule for the debt deal, vote ongoing

On late Tuesday, Fed’s Mester said:

·         No compelling reason to wait on rate hikes

On Wednesday, Fed’s Bowman said:

·         A pandemic-related surge of homebuilding and renovation has moderated, but important to understand the long-term impact on family formation and housing demand

·         Real-estate rebound affects the Fed's fight to ease inflation

·         While lowered rents will ultimately be reflected in inflation data and home prices themselves are leveling out

On Wednesday, Fed’s Collins said:

·         Fed is intent on reducing inflation

·         The Fed is intent on reducing inflation, it is simply too high

On Wednesday, Fed’s Jefferson said:

·         Conditions in the banking sector have stabilized, and the system remains resilient

·         The impact of tighter credit on the economy remains uncertain

·         The base case outlook is not for recession, higher interest rates and lower earnings could test the ability of businesses to service debt

·         Inflation remains too high and progress by some measures has been slowing

·         Monetary policy works with a lag, and a year is not long enough to feel the full effect

·         Skipping a rate increase at a coming meeting would allow Fed officials to see more data before deciding on the extent of additional tightening that might be needed

·         Holding the US central bank's policy rate constant at a coming meeting should not be taken to mean rates have reached a peak for this tightening cycle

·         The Fed staff working diligently on the Basel-III proposal, expected to be issued for public comment soon

·         Inflation is still too high, but progress is slowing recently

·         Higher rates could exacerbate banking stress

·         A pause at a coming meeting doesn't mean rates are at a peak

On Wednesday, Fed’s Harker said:

·         I am in the camp where we can skip a meeting

·         We need some slowing in the labor market

·         The Fed doesn’t have to hike at every meeting

·         Labor is driving core services inflation, in my view

·         A pause says you may hold there for a while, and I don't know that we're ready for that

·         It would be a skip, not a pause

·         I am in the camp coming into this meeting we can skip a meeting

·         Data still to come may change my mind

·         Inflation is stubborn, but likely to come down over time

·         Unemployment is going to tick up to around 4.4%

·         Our modal forecast is not for a recession

·         The economy is incredibly resilient

·         This economy keeps chugging along

·         I expect to see bank mergers but not major problems like in the past

·         There are no signs of inflation expectations being unanchored

·         I am not seeing so much a credit crunch as a credit squeeze following SVB

·         Fed's Harker when asked about the neutral rate: The jury is out on whether it has changed

On Wednesday, it seems both Fed’s Jefferson and Harker batted in a coordinated way for a possible pause in June, although it may not be seen as a pivot; Fed may hike later depending on the data.

On Wednesday, Fed’s latest Beige Book noted:

·         Conditions in the broad finance sector continued to worsen in recent weeks at a similar pace to the last reporting period

·         Small to medium-sized banks reported lower loan demand across all loan segments

·         Service sector activity declined moderately in the latest reporting period

·         Consumer spending continued to increase at a steady clip in the latest reporting period

·         Contacts across districts also noted that the labor market had cooled some

·         Employment increased in most districts, though at a slower pace than in previous reports

·         Prices rose moderately over the reporting period, though the rate of increase slowed in many districts

·         Employment increased at a slower pace

·         Future growth expectations deteriorated slightly

·         Economic activity was little changed overall in April and early May

·         Contacts across districts noted some cooling in the labor market

Market wrap:

Late Wednesday, Wall Street Futures recovered on hopes of a Fed pause in June and an imminent passage of the US debt/budget deal. Dow Future slips around -130 points, while SPX-500 and NQ-100 futures lost almost -0.6%. Advance Auto Parts plunged on guidance cut. HP tumbled on an earnings miss. For May, the Nasdaq gained 5.9%, and the S&P 0.3%, led by AI-related stocks while the Dow lost 3.3%.

On Wednesday, Wall Street was dragged by energy (lower oil as OPEC+ may not cut despite Chinese slowdown); industrials; banks & financials (possible higher regulatory capital/buffer as par BASEL-III); materials; techs; consumer discretionary and communication services, while supported by utilities (lower bond yields); healthcare, real estate (Fed pause in June) and consumer staples.

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%. But if Fed goes for a pause in June and the US debt deal is passed by 5th June, expect a risk-on rally and Dow Future may scale 34380 levels soon from around 32950 currently; 32500-400 is now a vital support zone (technically).