Pressure’s Up A Notch

By Maartje Wijffelaars, Senior Macro Strategist of Rabobank

Yesterday we learned that the US economy has been performing better than thought, ironically partly because of a detected fraud. Indeed, while initial jobless claims did rise by 4k in the week to 20 May, they have in fact come in 13k(!) lower than in the week before – and 16k lower than expected. This twisted math has been made possible by the detection of a major fraud in jobless claims in the state of Massachusetts, where claims have been revised down by 50,000 in the two weeks up until 13 May. Furthermore, US GDP growth for the first quarter was revised up from 1.1% to 1.3% QoQ on an annualized basis. Personal consumption growth was strong at 3.8%, the strongest figure in almost two years.

However, it didn’t keep DBRS from following Fitch’s move on Wednesday, putting the rating for the US under review with negative implications. While it still expects debt ceiling talks to be concluded in time, the risk that they won’t cannot be neglected. DBRS made clear that a downgrade to “selective default” would happen immediately once Treasury misses a payment related to its debt obligations. Interestingly, other missed payments over a “meaningful period of time” or a high risk of frequent debt ceiling standoffs in the future – even if this one is solved in time – could also lead to a downgrade. Later during the day, Moody’s commented that it keeps an eye on the USD 2 billion interest payments due on 15 June. If the Treasury would not be able to make the payment, Moody’s will downgrade its US rating by one notch from AAA to AA1.

Reuters last night reported that Biden and McCarthy are close to reaching a deal that would raise the debt ceiling for two years. The deal would include spending caps on almost everything apart from defense. How exactly ‘close’ is defined is unknown – earlier in the evening it was reported that Republicans still required more spending cuts worth USD 70 billion – and a temporary suspension of the debt limit might still be necessary. At the same time, as the X-date is approaching fast (1 June according to Janet Yellen), the risk of an accident is also growing. In a note last week, our US strategist Philip Marey stated that a suspension of the debt limit is likely, but he also underscored that the risk is substantial that the X-date will pass without an agreement on anything, and hence that some payments would be missed. According to the Wall Street Journal, the administration is preparing a contingency plan, but supposedly it does not yet mention any prioritization of payments. It rather discusses how to deal with a breach administratively.

In our view, it seems likely, however, that in a scenario of too little cash, the administration would try to favor bond holders, to prevent an official default and the subsequent expected significant financial market repercussions. To be clear, market reaction is likely to grow as time progresses and the ongoing uncertainty is certainly not going to benefit the economy – which we already project to enter a recession in the second half of the year, but we are not seeing the pressure that we would expect in the event of default. While certain money market rates have increased, longer-term yields barely seem to respond and the S&P500 yesterday even recovered some ground that had been lost since the start of the week.

The impact of economic overperformance so far seems to be stronger than that of the risk linked to breaching the debt ceiling. Meanwhile, even though some Fed officials suggested the central bank should step in in case of turmoil resulting from a breach of the debt ceiling, the looming accident doesn’t seem to give way for a pivot. There clearly is disagreement over whether they should pause or go ahead hiking, however. Indeed, multiple speeches and Wednesday’s FOMC comments showed a clear divergence in opinions. We still expect the Fed to take a pause from June. But if the credit tightening anticipated by the Committee fails to materialize, more hikes beyond that meeting might be required to get the inflationary pressure under control.

Speeches, the minutes, good economic data – with especially services holding strong throughout Q2 according to the PMI – and upwardly revised inflation for Q1, have also led to the market pushing backwards its expectations of a Fed pivot to the end of this / early next year. In fact, a July rate hike is now almost fully priced in, supporting the dollar. We project the dollar to gain some more ground in the coming months.

This despite the fact that we, like the market, expect more rate hikes by the BOE – especially after the strong inflation figures this week – and the ECB. Indeed, yesterday’s weak German GDP figures are unlikely to deter the ECB with headline inflation at 7% and core inflation at 5.6% in April and wage pressures still building. This was underscored by speeches from different ECB members yesterday, including de Guindos, Villeroy, Nagel and Knot, all of whom in different wording confirmed our thinking that the ECB will continue to hike in the coming months. Opinions do seem to differ in terms of how long the ECB will need to continue hiking, however, before taking a pause to monitor the impact of past hikes.

We continue to project two more ECB hikes, one in June and one in July. But we also believe that rates are likely to stay high longer than the market is currently projecting, with upward and downward risks to that hiking profile more or less balanced. PMI surveys this week underscored that while price pressures in the manufacturing sector are receding, they are still strong in the services sector. Next week we will get the first estimates of inflation in May. We believe the figures will show that inflation has softened, but that core inflation proves to be sticky. Further ahead, food and core inflation will slow gradually, while especially the energy component will act as a drag on headline inflation. Base effects and the major ongoing decline in wholesale gas prices will lead to large drops in YoY price developments.

Dutch TTF one-month ahead currently sits at EUR 25.15 per MWh, a two-year low, as a result of a variety of factors. A warm winter has led to fill levels far above normal levels at this time of the year, Chinese spot demand has not returned as expected after its reopening, and also industrial demand in Europe remains weak despite the major fall in prices. Remember, last year many factories have been mothballed due to the high gas price, but while certain production has returned, weak demand currently seems to prevent a further uptick. Due to the rather weak economic outlook at home and across the globe, industrial demand is likely to remain below average for the remainder of the year.

Given recent developments, we might temporarily see negative wholesale prices over summer, although at the same time, heavy droughts in the south of Europe might also lead to above average summer gas demand, due to weak hydro and nuclear power, like last year. In any case, after summer, gas prices are still likely to pick up again from current levels. While Chinese demand remains a gamble, heating demand in autumn and winter will require more LNG imports over those months, supporting prices. Still, barring any major event, it seems very unlikely we will return to the heady prices seen in Q3 2022.