There once was a poet who wrote
‘Bout foreign exchange in a note
Right now he’s at home
Though, yet, he may roam
For now, though, enjoy, please, each quote

Meanwhile, for the week that has passed
The debt drama has some aghast
So, markets are guarded
While we are bombarded
With stories this drama can’t last

Since I last wrote, the dollar is broadly stronger, stocks have managed to continue to rally, and bond yields have risen to the top end of their recent trading range with the 10-year at 3.65%.  But really, it seems that despite a weak Retail Sales print last week, and some other mixed data, all eyes are really turning to Washington and the ongoing debt ceiling negotiations between President Biden and House Speaker McCarthy.  At this point, while the House has passed a bill that includes a significant, $1.5 trillion, debt ceiling increase, although combined with spending cuts over the next decade that amount to ~$4.5 trillion, the President has proffered nothing other than a resounding No.  Ultimately, this is a political calculation as to the President’s belief he can blame any negative outcome on McCarthy and the Republicans, although that remains to be seen.

At the same time, we continue to receive apocalyptic warnings from Treasury Secretary Yellen, as well as various other officials, politicians, and bank CEOs.  And there is no doubt that an actual US default would be extraordinarily bad for pretty much everyone.  However, as Winston Churchill has been credited with saying (though remains true whoever said it), Americans can always be counted on to do the right thing…once every other choice has been exhausted.  We have seen these political dramas before, and I have no doubt we will see them again in the future but in the end, nothing has changed my view that a deal will be struck and there will be no apocalypse, at least not this time.

So, what does that mean when that deal is struck?  Well, ironically, one of the drivers of recent equity market strength has been the running down of the Treasury General Account (TGA) at the Fed.  That is the Treasury’s ‘checking’ account from which they pay all the US’s bills.  As can be seen from the below chart, post the GFC, the average balance has been in the $200 billion range, although there have obviously been several enormous peaks during the Covid situation.  For context, prior to the GFC, the TGA balance averaged just $5.8 billion.  Perhaps there is no better description of what QE has done than this, as well no better signal of today’s inflation and its causes than this fact.

Data Source, FRED database

The problem is that number has been shrinking, maintaining liquidity in the market that might otherwise not be available.  In fact, one of the key concerns in the market right now is that when the debt ceiling is finally raised, the Treasury, which through its extraordinary measures has been running down balances as well as delaying payments into government pension accounts and the like, will need to issue a significant amount of new debt, perhaps up to $1 trillion pretty quickly, which will suck a lot of liquidity out of the equity market as investors look at the return on T-bills and conclude safety at a 5% yield is very attractive.  Clearly, tax receipts are another part of the puzzle, but recent receipts have been coming in lower than forecast adding more pressure to the Treasury.  

The point is that one needs to be careful in expecting that the resolution of this issue will automatically have a bullish impact on risk assets.  In fact, it could be just the opposite, so beware.

As to this morning’s markets, mixed is an apt description.  While Friday’s US equity market performance was dull, with very modest declines, Asia saw gains overnight and Europe opened in the green.  Alas, European bourses have since turned lower although US futures are currently unchanged (7:30).  Given the potential impact on financial markets in the event the US does default, it seems likely that risk assets will struggle to gain much until there is a conclusion of this drama.

Bond yields, meanwhile, are continuing their drift higher from last week, although Treasury yields are unchanged at this hour.  In Europe, though, sovereign yields are edging up between 1bp and 2bps.  There is one place, though, where yields remain in check, Japan, where the 10yr yield, at 0.378%, remains far below the YCC cap and is exerting no pressure on Governor Ueda.

Oil prices (+0.3%) are a touch higher this morning having bounced off their lows from the beginning of the month but remain far below the post OPEC+ production cut highs from April.  As I have been writing, the commodity market seems to be the only one that is really pricing in a recession, with metals prices also continuing under pressure, including gold despite its haven characteristics.

Finally, the dollar is showing both gains and losses today in both the G10 and EMG blocs.  CHF (+0.4%) is the leading G10 gainer on what appear to be technical trading patterns more than new information.  On the flip side, the commodity bloc (AUD, NOK, CAD) is under very modest pressure this morning, but really not much to say here.  In the EMG bloc, ZAR (+0.65%) and KRW (+0.6%) are the top of the heap, ostensibly on the back of a dovish reading of some comments by Chairman Powell over the weekend.  However, there are a number of laggards, notably MXN (-0.5%) despite those same remarks.  Arguably, if they were truly that dovish, we would see the dollar softer across the board, something that has not been the case for a while.

Until the debt ceiling drama is over, I anticipate a relatively limited amount of market movement.  And when it is finally concluded, it will depend on the actual agreement, I think, to really get a sense of any medium- or long-term impacts.  Until then, trade the range.

Good luck
Adf