Fed talk on rate hikes hits Dow Jones, benefits Gold

The Dow Jones and NASDAQ 100 slipped by midday as earlier optimism on a Debt Ceiling agreement was offset by the fear that interest rates might rise again after a later speech by Fed Reserve Chair Jerome Powell. Fed fund futures moved to a more bearish position, now pricing in near equal odds of another rate hike at the June meeting earlier this week, and odds of another rate hike falling to just 18%.

TODAY’S MAJOR NEWS

Fed undecided on direction of rate rises

Powell’s mid-morning speech in Washington, DC focused on tightening credit, and sent stocks lower. Indeed, the Fed's survey of senior loan officers shows a sharp tightening in standards for loans at both the consumer and business level. This tightening of credit does much of the work for the Fed of slowing down the economy to tame inflation, although wage inflation is only just now starting to see some softening. However, there's still a lot of work to do before inflation returns to the Fed's 2% mandate. Powell also conceded: "The risks of doing too much or doing too little are becoming more balanced and our policy adjusted to reflect that." He went on to say, "We haven't made any decisions about the extent to which additional policy firming will be appropriate." (Author’s italics).

Bottom line – risk-off?

Equities look poised for risk-off days and bearish price action next week, with Gold leading as a risk hedge and high Beta equity indices like the NASDAQ 100 suffering.

TODAY’S MAJOR MARKETS

Equity markets

• The S&P 500 fell 0.3%, while the Dow Jones and NASDAQ each fell 0.4%
• The KBW Regional Bank Index fell 2.8%, after rebounding earlier in the week
• The FTSE 100 and DAX were up 0.2% and 1.0%, respectively
• The VIX, Wall Street’s fear index, rose 6.4% to 17.1

Currencies and Bonds

• The dollar index fell 0.4% to 103.0
• Euro/Dollar and Dollar/Sterling both rose 0.4%
• Yields on 2- and 10-year Treasuries again rose modestly to 4.25% and 3.70%

Commodities

• Gold prices bounced back by 1.2% to $1,984 per ounce
• Crude oil prices fell 0.4% to $71.6 per barrel
• Grain and oilseed sectors bounced after recent sharp losses

TODAY’S MAJOR STORIES

Debt ceiling talks will likely be resolved, but debt problem remains unaddressed

Negotiations continue between the White House and the House of Representatives on a debt ceiling package avert default on US national debt, currently $31.8 trillion. A deal needs to be reached before the Treasury Department runs out of creative accounting tricks to shift money around to make payments – generally believed to be very early June.

Both sides agree that default is not an option; both sides us this as negotiating leverage. Yet the process is actually controlled by a handful of lawmakers and bipartisan support could prove tough to obtain. Republicans have narrow margins in the House; Democrats have narrow margins in the Senate. However, fireworks notwithstanding, the financial market expects us to weather this storm and achieve a solution.

This this will not address the longer-term problem that the US continues to spend more than raises in taxes. This deal will not address the larger problem: interest payments on $31.8 trillion at today’s short-term rates would be $1.6 trillion, and in reality, it is “just” $570 billion because a lot of the debt is still held by existing debt certificates at lower rates. These payments will be rolled forward, and actual payable annual interest payments on the national debt are projected to be between $900 billion and $1.7 trillion four years from today, depending on what you expect interest rates to do over the next several years. That compares to projections that we will spend $1.7 trillion on Social Security payments four years from today, and over $900 billion on national defense.

The national debt is expected to be somewhere near $40 trillion plus/minus a couple of trillion dollars. Congress will need to deal head on with this issue over the next couple of years. That will require either a significant hike in taxes that would dramatically slow the economy, a dramatic cut in spending that neither party has shown an ability to accomplish, or monetizing the debt which devalues the dollar and is even more inflationary than we have seen to this point. Unsurprisingly, China is watching this play out, and it is positioning itself to take advantage of the opportunity to assume a leadership role in the world when it happens.

G-7 expected to tighten Russian sanctions

This week’s G-7 Summit in Japan is expected to see world leaders tightening sanctions on Russia, and putting pressure on Germany to stop a surge in exports to countries surrounding Russia which its believed are then re-exported to that country. The G-7 Summit also committed itself to supporting Taiwan, angering China. Momentum had been going China’s ‘world leader’ strategy earlier this year, but now the momentum seems to be swinging away from China, with many western nations increasingly concerned with China’s aggressive stance on global economic and military issues.

West and China at odds on Taiwan

Battle lines are being drawn on Taiwan’s independence, which China sees this as an internal matter of national security, and the West sees as an issue of freedom and free trade. The question now is, will either China or the West challenge the line in the sand in the Taiwan Straits, and what will the consequences of that be, both militarily and economically for world trade? One thing we do know is that it is already impacting trading decisions, with China increasingly seeking alternative sources of necessary commodities as it diversifies away from the US.

Analysis by Arlan Suderman, Chief Commodities Economist: Arlan.Suderman@StoneX.com

Market outlook by Paul Walton, Financial Writer: Paul.Walton@StoneX.com