Inflation, Interest Rates, and Debt Ceiling Outlook

From interest rates to the debt ceiling fiasco, market direction is dependent on a lot of moving cogs. So where are we moving now?
by Yoaquim Boom
May 27, 2023

Today, we'll be looking backward & forward into the markets. Looking at some of the statistics and the upcoming direction of the market.

To start off, the Federal Reserve's preferred gauge of inflation (PCE) has revealed that high and escalating prices continue to persist, increasing the possibility of another interest rate hike by the U.S. central bank in June.

According to the government's personal-consumption expenditures (PCE) price index released on Friday, prices increased by 0.4% in April on a month-over-month basis, slightly exceeding the consensus forecasts of economists surveyed.

The core PCE reading, which excludes volatile food and energy prices, also saw a 0.4% increase on a monthly basis, up from a 0.3% rise in March.

This surge in the PCE index was partially driven by rising service costs, including medical care, transportation, and hospitality, which climbed by 0.4% in April and exhibited an annual growth rate of 5.5%. Goods prices experienced a monthly increase of 0.3% and rose by 2.1% compared to the previous year.

Andrew Patterson, Senior International Economist at Vanguard, expressed concern over these developments, stating that the pickup in service prices is unfavorable for the Federal Reserve's efforts to bring inflation back down to its target level. The increase in PCE, even over short-term month-over-month gauges, is not what the Fed is looking for here.

Stock prices are rallying but inflation continues to rise even if ever so slightly. At the current rate, the Fed will raise interest rates again, and we'll see a relatively large size drawback in stock prices in the upcoming year.

The minutes from the Fed's May 2-3 policy meeting revealed that members of the Federal Open Market Committee (FOMC), the Fed's policymaking arm, have already acknowledged that inflation remains persistently "too high."

Several officials expressed concerns about the potentially slow progress in reducing inflation to the 2% annual target, deeming it "unacceptably slow."

The latest increase in inflation may offer sufficient grounds for some FOMC members to advocate for further interest rate hikes during the upcoming June 13-14 meeting.

However, there is also uncertainty among committee members regarding the extent of additional policy tightening that may be deemed appropriate.

On Thursday, the Bureau of Economic Analysis revised upward the growth rate of first-quarter U.S. gross domestic product (GDP), reporting an annual growth rate of 1.3% for the period. Relatively far below the ideal GDP growth rate of 2% to 3%, yet this figure surpasses economists' estimates of 1.1% growth.

Andrew Patterson predicted that the bumpy road to subduing inflation will likely result in another interest rate hike during the June 13-14 FOMC meeting. I have a similar feeling about the upcoming FOMC meeting. I deem it not just likely but necessary to increase rates again in order to reset the markets some more, people remain to risk on in a risk-off environment.

Now, let's add to this with the Debt Ceiling fiasco.

President Joe Biden and House Speaker Kevin McCarthy appear to be on the verge of reaching an agreement to address the impending debt ceiling issue, which is certainly a positive development.

The deadline for the U.S. to meet its financial obligations is projected to be this Thursday (Jun 1), with the Memorial Day weekend falling in between.

Reports suggest that an outline of the deal has emerged, encompassing a two-year increase in the debt ceiling and a cap on federal spending.

There is also speculation that the agreement may include measures to reclaim a portion of the $80 billion allocated by Congress to bolster tax collection efforts at the Internal Revenue Service. However, the sources providing this information remain anonymous.

Both McCarthy and Biden have expressed that progress is being made in the negotiations. McCarthy informed reporters that although some outstanding issues remain, he has instructed his teams to work around the clock.

Treasury Secretary Janet Yellen has emphasized the significance of reaching an agreement by June 1 for various reasons.

Economists at Goldman Sachs anticipate that June 1 remains a highly probable date for an agreement. They predict that an announcement regarding the deal could be made on either Friday or Saturday.

The uncertainty surrounding the agreement has sparked concerns in the $4 trillion municipal bond market, as cities heavily rely on federal funding. Earlier this week, major rating agencies issued a warning about U.S. bonds as negotiations continued without a resolution.

Once the debt-ceiling soap opera ends, investors will likely turn their attention to some of the tailwinds supporting stocks.

These include stronger earnings growth, diminished bank stresses, better housing data, early signs of an up-leg in the manufacturing cycle, the prospects of an AI-driven productivity boom, and the fact that labor slack has managed to increase without rising unemployment.

Overall, in my estimation, investors should resist turning too bearish on stocks for now but look to become more defensive later this year. Look for things to begin to show weakness, and pounce on that weakness once it’s there because it will be a lot of sustained weakness in my estimation.