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Debt ceiling jitters increase

Surprising precisely no one, US politicians appear no closer to resolving the debt ceiling debacle, and evidence of stress is emerging across a range of previously-immune asset classes. One-month Treasury yields are above levels reached ahead of the 2008 global financial crisis, equity markets are down, and the dollar is catching a sustained bid as investors prepare for an 11th-hour deal – or a technical default – that triggers a short-lived worsening in liquidity conditions.

Republican House Speaker McCarthy yesterday said “We are not putting anything on the floor that doesn’t spend less than we spent this year,” but is pushing a proposal that would limit revenue gains and increase defence outlays. Democrats have offered to freeze spending, but  are fighting to avoid increased work requirements on benefit programs and a withdrawal in unspent Covid-19 aid. Negotiators on both sides are struggling to find a solution that could gain approval within an unusually-polarized Congress, even as some representatives say they don’t believe the debt ceiling deadline articulated by Treasury Secretary Yellen is valid, and heed former President Trump’s call to “do a default”.

The brewing crisis comes as the underlying US economy continues to outperform expectations. The latest raft of S&P purchasing manager surveys, released yesterday, showed economic activity ratcheting up to a 13-month high in May, with growth in services spending offsetting a slowdown in the (far smaller) factory sector to confound persistently-bearish market forecasts.

Perversely, evidence of strong underlying demand could complicate the Federal Reserve’s response function beyond the debt ceiling deadline. By raising inflation risks and limiting the extent to which officials might be willing to open the liquidity taps or engage in yield curve manipulation (à la 2011’s “Operation Twist”) when the Treasury restarts issuance, robustness in the real economy could shrink the policy cushion that prevented deeper market upsets around previous political stalemates.

Inflation slowed by less than expected in the UK last month, bolstering odds on another rate hike at the Bank of England’s June meeting. The Office for National Statistics earlier this morning said consumer prices rose 8.7-percent year-over-year in April, down from 10.1 percent in March, but above the 8.4 percent expected in markets as last year’s energy price cap fell out of the annual comparison. More worrisomely, core prices – which in the UK exclude energy, food, alcohol and tobacco – climbed 6.8 percent, accelerating from 6.2 percent in the previous month. The pound surged as terminal rate expectations jumped toward the 5.5 percent mark, and gilt prices plunged toward levels last seen during the ill-fated Truss budget in September. In yesterday’s Parliamentary testimony, Governor Andrew Bailey admitted the Bank of England had made errors in forecasting inflation and adjusting monetary policy settings during the post-pandemic period, saying there were “very big lessons to learn”.

Today should be another quiet one: Fed governor Christopher Waller will deliver an economic outlook shortly after noon, and the central bank will release minutes from its May 2-3 meeting at two o’clock. Market participants will focus on any hints of a thaw in the long-standing “higher for longer” mantra, but are likely to be disappointed for now, with inflation risks remaining front and centre and a number of critical data releases set to be released between now and the next meeting.

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