Warning: X-Dated Content

By Bas van Geffen, Senior Macro Strategist at Rabobank

Treasury Secretary Yellen notified Congress on May 1 that the government may exhaust its ability to honor all of its obligations by early June already, and potentially as early as June 1. Yellen’s warning about the so-called X-date piled a lot more time pressure on the negotiations between the Democrats and the Republicans to agree on a deal to either suspend or raise the debt limit.

The debt ceiling negotiations were always expected to last until the eleventh hour, with both sides of the aisle playing a game of chicken. Yet, few had expected the clock to be moved that much forward. When the debt ceiling came into sight earlier this year, 1-month T-bills started trading rich on the belief that the timing of any potential default would only be after the maturity dates of this very short-term paper. That premium has evaporated since the start of the month, and even turned into a discount over the past week.

Adding an extra time constraint to the mix, President Biden is due to fly to Japan next week for the annual G7 summit – although he indicated that he might cancel his travel plans if the debt limit discussions drag on. Lawmakers, meanwhile, have ramped up their negotiations. President Biden and House Speaker McCarthy met on Tuesday, although the hour-long talks resulted in little more than the commitment to daily discussions between their staff, and a new meeting being scheduled for today. But the pressure may not be high enough yet to force either side to give in. Indeed, CNBC reports that this follow-up meeting has been pushed back to ‘early next week’, according to a source.

That raises the risk of an accidental default, if the Treasury runs out of cash and fiscal creativity sooner than Ms. Yellen expects. Yet, even if such a default is ultimately averted –as has been the case in all of the previous debt ceiling stand-offs– the sheer uncertainty around the debt limit may already be sufficient to damage the economy.

This comes on top of the regional banking crisis that continues to drag on, so it’s easy to explain why the Fed has opened the door to pausing –or potentially ending– the hiking cycle next month. The US CPI data earlier this week did little to change that outlook.

As we noted last week, that could put the US central bank on a different course than its European peers. The ECB acknowledged last week that they weren’t quite ready to consider a pause in their hiking cycle, and the central bank’s hawks have been busy talking up the odds of a hike in September – which would take the policy rate to 4%.

While we certainly can envision such a scenario, isn’t it a bit early for policymakers to discuss the situation three meetings ahead? Especially if we consider that the ECB has repeated ad nauseam that it will set policy on a meeting-by-meeting basis. This suggests that a) there may have been a bit more compromise last week than some of the hawks preferred, and/or b) that there is a group of policymakers that still very much fears the inflation outlook and markets potentially pricing in an earlier ECB pivot which would reduce the efficacy of policy tightening to date.

Such fears are arguably justified, considering that the ECB’s Consumer Expectations Survey saw inflation expectations increase “significantly”, particularly over the medium-term. After declining somewhat in recent months, the median inflation expectation for the three years ahead jumped back to 2.9%. Consumer expectations are notoriously linked to recent inflation developments, and thus this revival in inflation expectations could be related to the increase in news items about e.g. ‘greedflation’. The reversal of the downward trend is a warning sign that expectations could still de-anchor from the ECB’s 2% aim.

The Bank of England joined the ECB yesterday in flagging that inflation risks remain significantly skewed to the upside. The Bank raised its CPI forecast for 2024 from 1.0% to 3.4%. That’s not a modest tweak to the forecast, and a strong signal that rate cuts will not be coming as fast as some market participants are expecting. It also increases the odds that the Bank of England may have to tack on more hikes than the final +25bp we have currently pencilled in for June.

Indeed, Europe may still be in a very different spot when it comes to bending the current inflation back to target. The continent remains ill-positioned for the evolving geo-economic scenario of global fragmentation. It lacks many of the elements required for strategic autonomy, from commodities and resources to domestic production capacity and military firepower. And rebuilding those, while fully possible, is certainly not free.

In a Financial Times op-ed, French President Macron campaigns for a European re-industrialisation strategy, and an increased effort to regain Europe’s economic sovereignty. Macron’s proposed five-pillar approach is a mix of greater competitiveness, subsidies, and protectionism. “’Made in Europe’ should be our motto,” he stresses. Who knew Trump spoke French?

The timing of this op-ed is at least a bit curious. It coincides with a Chinese delegation led by the vice president touring Europe, visiting several countries in an attempt to rekindle some of the diplomatic ties. Germany still appears to be the continent’s soft spot. On Wednesday, the German foreign minister said they want to work in partnership with China “everywhere it’s possible”, without ignoring the risks of overreliance. The realisation that Europe must stop being dependent on other countries is Germany taking one step into the right direction. But surely Macron will want to point out to his German colleagues e.g. the lack of reciprocity when it comes to trade with China.