All quiet on the Western Front. Perhaps too quiet.

Mon 22 May 2023

It was an undeniably good week for markets. US equities rose, breaking their ceiling, which held from September. This was down to two simple reasons: The closing in of a debt ceiling deal and a perhaps slightly more dovish Fed.

Republicans and Democrats seem to be close to a debt ceiling deal.
Some dovish comments by Fed officials, especially at the end of the week, which suggested that the US central bank could pause rate hikes for the time being.

On the one hand, the US Republicans and Democrats have ostensibly climbed off their high horses and decided not to play too many games with the debt ceiling and the nation’s credit standing. It is not just the optimism from both President Biden and House Speaker Keving McCarthy, but, perhaps more importantly, it is the absence of the usual acerbic accusatory language, concomitant with brutal partisan fights. In the past few months, the “de-dollarization” theme seems to be in vogue. It started some time after SVB’s collapse, and before the debt ceiling was trending.

Is it possible that the leaders of the biggest economy in the world are uniting in front of rising danger against US economic primacy?

The climate between President Biden and House Speaker McCarthy seems positive enough. As a personal caveat, however, this writer is too old, too suspicious of current politics and perhaps too cynical to casually believe politicians singing ‘Kumbaya’. Where I hear unfettered optimism coming out of Washington, I instinctively embrace my natural proclivity towards facetiousness, ever mindful of George Orwell’s quote: “Political language is designed to make lies sound truthful […] and to give an appearance of solidity to pure wind”.

Investors and markets should not mistake political communication for a ‘central bank forward guidance’ type of dictum. What may appear as ‘closing comments’ could easily prove to be ‘opening salvos’ in a blame game by two sides determined not to reach an accord. “We had every good intention, but the other side…”

Equally dangerous is that we haven’t seen the details of this deal-in-the-making. Nowhere is the devil more comfortable than in the details. It could very well be the case that there’s a real deal ready to be signed, but also that the ‘Grand Compromise’ will end up hurting growth over the long term, much like it did in 2011. Short-term fast money, which cares little about fundamentals, may have good reason to celebrate. Long-term investors, however, should wait until the debt ceiling deal is signed, the ink is dry and all details have been scrutinised before even considering uncorking the champagne bottles.

On a similar note, markets seem to be a bit too relaxed with the Fed. On Friday, Chairman Powell quelled some fears that the Fed would hike again in the next meeting. Comments by some voting Fed officials earlier, especially by Dallas Fed President Lorrie Logan who is seen as close to the Fed Chair, caused some concerns: “The data in coming weeks could yet show that it is appropriate to skip a meeting. As of today, though, we aren’t there yet”. Powell, on the other hand, said that the Fed would pivot from a rate-hike cycle to a meeting-by-meeting decision-making process. He also intoned that “policy rate may not need to rise as much as it would have otherwise to achieve our goals”. Following suit, Neil Kashkari, Minneapolis Fed President and voting dove-turned-hawk suggested that “I’m open to the idea that we can move a bit more slowly here”.

The Fed undeniably walks a tightrope. On the one hand it seeks to quash the persistent narrative that it’s done with rate hikes and will proceed with rate cuts by the year’s end. The bond market continues to believe this is the case.

On the other hand, it can’t afford to appear too hawkish. The turmoil in peripheral banks persists, lending is drying up and the debt ceiling rising is not a done deal. The central bank’s credibility and ability to influence markets had to be carefully and painfully rebuilt after misreading inflation two years ago. It remains fragile and could collapse like a house of cards if it persisted on rate hikes only to renege a month later due to worsening financial conditions.

So it needs to communicate very carefully and mean what it says. And what it is very clearly saying is that “we may be done, or we may not be done yet, we don’t yet have the data to know for certain”. Investors sometimes prefer to listen to their ‘gut’ as opposed to the actual commentary by policymakers. As an investment strategy, we don’t put much stock in the clairvoyant powers of one’s intestines. Instead, we prefer to take the Fed’s words at their exact face value.

This was an excessively long Monday letter, which could just have been summarised in two bullets: