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Markets count down to debt ceiling deal

Markets are stuck in a state of suspended animation after President Biden and House Speaker McCarthy emerged from last night’s talks without a deal to raise the US debt ceiling. According to Biden, the two leaders agreed that a “default is off the table,” and McCarthy said “The tone tonight was better than any other time we have had discussions”. McCarthy called the talks “productive” but said “we don’t have an agreement yet,” with both noting that differences over tax changes were lengthening the standoff.

An earlier statement from Treasury Secretary Janet Yellen said “we estimate that it is highly likely that Treasury will no longer be able to satisfy all of the government’s obligations if Congress has not acted to raise or suspend the debt limit by early June, and potentially as early as June 1,” warning that “waiting until the last minute to suspend or increase the debt limit can cause serious harm to business and consumer confidence, raise short-term borrowing costs for taxpayers, and negatively impact the credit rating of the United States. In fact, we have already seen Treasury’s borrowing costs increase substantially for securities maturing in early June”.

The dollar is holding steady, but front-end Treasury yields are elevated, with those most exposed to a potential default – one- and two-month bills – ratcheting ever higher as the deadline approaches. 

The euro is trading at slightly lower levels after the latest purchasing manager indices turned more negative than expected. According to an update from S&P Global this morning, the euro-area composite index inched down to 53.3 from 54.1 – still firmly in expansionary territory as services activity held up – but the manufacturing sector tumbled further into contraction, with the bellwether German index hitting 42.9, well below the expected 45.

The pound is even weaker, down against both the euro and the dollar after S&P’s composite purchasing manager index slipped to 53.9 in May, down from 54.9 in April as factories slowed and services activity slipped. In tomorrow’s April consumer price update, the UK is expected to report a substantial decline in headline inflation, helping bolster the case for a pause at the Bank of England’s June meeting. Consensus estimates suggest prices climbed 8.3 percent relative to the year before, down from 10.3 percent in March after a 54-percent rise in the energy price cap, originally implemented in April 2022, fell out of the inflation calculation. The core measure, which excludes food, alcohol, tobacco, and energy is seen rising 6.5 percent year-over-year, up from 6.2percent in the prior month – warm enough to support rates at current levels, but potentially not hot enough to make more tightening necessary.

The day ahead should be a light one from a data perspective. S&P Global is likely to report a modest softening in its US purchasing manager indices in early May, with manufacturing sentiment seen slipping to 50.0 – on the threshold that divides expansion from contraction – from 50.2 in the prior month.

A record of the Federal Reserve’s last meeting, out tomorrow, should show policymakers were relatively unified in supporting a pause at the upcoming June meeting, with markets carefully reviewing opinions on the balance of risks represented by still-robust consumer demand and an ongoing tightening in credit conditions for what they might say about the likelihood of rate cuts later in the year. The April Personal Consumption Expenditures report, out on Friday, is expected to show headline prices accelerating on strong income gains and extensive auto buying activity, while the core measure is seen maintaining the previous month’s 0.3-percent pace.

All that said, updates from the debt ceiling negotiations are likely to overwhelm any economic fundamentals in driving price action through the remainder of the week. We think a deal will be announced within days, and that markets will rally reflexively, with risk-sensitive currencies and asset classes outperforming the dollar as investors heave a collective sigh of relief. Commodity prices, including oil, could jump, and the Canadian dollar might push a couple of cents higher as credit tightening goes into reverse, seemingly building a more compelling case for additional rate hikes from the Bank of Canada.

But the longer-term implications will be more complex. Although the deal’s provisions could exacerbate the fiscal drag facing the US economy, history suggests a sequential worsening in expected global growth rates will soon follow. The liquidity environment might evolve in unexpected ways as the Treasury ramps up issuance and hoovers up private capital. And a broad-based easing in financial conditions could prompt a renewed revision in rate expectations from the Federal Reserve, with cuts taken off the table for the latter half of 2023. Despite an almost-universal dollar-bearish mood among the major banks, we think directional bets on a greenback decline could prove more dangerous than many participants currently expect.

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