Agreement On U.S Debt Ceiling Unlikely Before Last Minute

U.S. stocks started the week on a slightly positive note after weak economic data fueled expectations of a pause by the Federal Reserve (Fed), hopes of a resolution in the debt ceiling talks between Joe Biden and Kevin McCarthy, and Microsoft received EU approval to buy Activision.

However, the latter are all weak reasons to jump on an upward trend, because,

1. New York’s Empire State manufacturing index fell to -31.80 in May, while analysts had expected a drop to around -3.70. Minneapolis Fed head Kashkari, however, warned investors that the Fed will continue to raise interest rates. Bostic of the Atlanta Fed said the Fed should hold rates this year but definitely not cut them, while Goolsbee of the Chicago Fed wouldn’t promise a rate pause in June. He said he’s watching the data and remains ‘particularly vigilant about the impact of rate hikes on credit conditions.”

While a Fed rate hike in June is still off the table, activity in fed funds futures suggests investors see higher odds of a rate hike next month. The probability of a 25 basis point rate hike is now at 19%. But of course, the data and the progress of the debt ceiling talks will be key to what the Fed could and would do.

2. Although investors have given up hope for a possible breakthrough in the U.S. debt ceiling dispute at today’s meeting between Biden and McCarthy, McCarthy cautioned that they are “a long way from reaching a conclusion.” Negotiations are likely to remain tense as Republicans demand decent spending cuts to accept debt ceiling relief, while Biden is unwilling to compromise on spending into the election year. Thus, even if Biden were to concede, it would be better if he did so at the last minute to show his constituents that he has done his best to avoid an otherwise inevitable default. Anything else would probably be a political mistake.

Against this backdrop, it is unlikely that we will see a solution to the U.S. debt ceiling problem today. And that’s certainly why U.S. 2-year yields moved higher yesterday despite the scary results from the NY manufacturing index. The 2-year yield is once again in a tight range around 4%, with upside risks emerging in the near term, which could lead to an interesting buying opportunity at a discount for investors betting that the U.S. will default on its debt obligations and that the Fed will ease policy before the end of the year.

P.S. For investors, default means that the U.S. government is defaulting on its debt. Period. Investors do not really care whether U.S. government employees get paid or not. They only care about whether the U.S. will be able to service its debt. So there is a nuance here. And even in an extreme case like 2013, when the U.S. government shut down for weeks, it was not considered a default because 1. The U.S. did not default on its debt payments, so frankly for investors, there was no default at all. Even policymakers did not call the 2013 government shutdown a default, but said it was simply a ‘lapse in appropriations.” So even in the event of a government shutdown, the U.S. can avoid a real default.

3. Microsoft has received EU approval for its purchase of Activision. The European Commission says its analysis shows the huge $69 billion acquisition would not harm competition because Microsoft will allow its cloud rivals to offer titles like Call of Duty on their own platforms for ten years, but regulators in the U.S. and U.K. are not convinced. UK regulators have made it clear that they stand by their decision that the acquisition will not be approved

Weak Chinese data

The latest economic data from China showed that retail sales and industrial production grew more slowly than expected in April, while fixed asset investment unexpectedly fell. Crude oil traded above $71 yesterday on news that the People’s Bank of China is increasing liquidity to spur growth in China. However, until the hard data is available to confirm improved activity, it will be difficult for oil bulls to justify a move above the 50-DMA, which is slightly below $75.

Moving forward

Investors will be keeping an eye on European growth and sentiment data, U.S. retail sales and Home Depot earnings. In the coming days, other U.S. retailers such as Target and Walmart will also report their results, which will shed light on how U.S. consumers are coping with stubbornly high inflation.

The latest GDP report showed surprisingly robust consumer spending – which in turn puts positive pressure on inflation expectations and Fed bets. Therefore, any further recovery in retail profits would put Fed hawks on alert.