"The Payoffs Here Are Very, Very Asymmetric. Somebody Has To Make A Move"


By Benjamin Picton, senior strategist at Rabobank

Your Move

Republicans have managed to pass a bill through the House of Representatives which would lift the US debt ceiling by $1.5 trillion. The quid pro quo for agreeing to the lift is swinging cuts to spending on social programs, which the Democrats have repeatedly balked at. Democrat Senate Leader Chuck Schumer has already said that the bill will be “dead on arrival”, but the mere fact that his Republican counterpart in the House, Kevin McCarthy, has been able to stitch together enough support for the bill from his own deeply divided party really puts the heat back on the Democrats. It’s not quite ‘put up or shut up’ time just yet, but with experts warning that a potential default is only weeks away things are starting to look dicey.

Indeed, as this Daily reported only yesterday, Janet Yellen has said that a US default would be an “economic catastrophe”. But despite the rhetoric, markets have been relatively sanguine. The S&P500 sold off by half a percent yesterday as US durable goods orders came in softish (once you strip out aircraft purchases) and Brent crude dropped below $80/bbl for the first time since late March. The NASDAQ was up on the back of strong earnings results from Microsoft and Google the day before, and Meta posted healthy numbers after the close. There is a ‘boy who cried wolf’ element about the debt ceiling situation. Markets have seen this movie so many times before that nobody really believes that the politicians will allow a default to occur. The payoffs here are very, very asymmetric. Somebody has to make a move.

This isn’t to say that markets don’t care for financial stability stories. They clearly do. Just look at the price action in First Republic stock over the last few days after the bank’s admission on Monday that it had lost $100bn in deposits since the banking turmoil began. The stock was down another 30% yesterday as hopes faded that a white knight would arrive to buy up First Republic’s assets at an above market price. Nobody seems to be hot for that deal.

If the only hope is a buyout on non-commercial terms, then that means that the government is the only logical buyer. But the problem with that is that the government doesn’t want to get involved. Paying overs for assets that nobody else will buy at the same time you’re negotiating a lift in the debt ceiling would be a dreadfully bad look. That is a problem that Joe Biden doesn’t need as he launches his campaign for re-election in 2024. Just ask George W Bush about the politics of taxpayer bailouts for distressed bank assets.

The point here is that markets are again looking in the wrong direction. While price action is focused on the tree of idiosyncratic bank risk, it is missing the enormous forest of a potential default on securities that are the world standard for creditworthiness. That would really move markets.

Of course, the banking crisis finds its genesis in higher interest rates (or is that lower rates, followed by higher rates?) and there were further developments on that score yesterday. ECB speakers Herodotou and de Guindos were both in action, and both continued the hawkish tone set by their colleagues in recent days. De Guindos talked up the improving growth prospects for the Eurozone, noting that a first quarter recession “is not going to take place” and also highlighting the strength of the European labour market, which he says will see further acceleration in wages growth. Meanwhile, Herodotou seemed to borrow some of Christine Lagarde’s notes from last week by saying that “trade fragmentation is another area to monitor”. That is central banker speak for “expect more supply side shocks”.

Indeed, in this new era of Great Power competition the distinction between geopolitics and markets is hardly worth making. The two are intrinsically linked by governments seeking to dragoon central banks and corporations into serving the strategic interests of nation states. On this score, Reuters is reporting this morning that Argentina will now pay for Chinese imports in Yuan rather that US Dollars. As my colleague Michael Every – who flagged just this risk in recent days – has been at pains to point out, we are not witnessing the replacement of the dollar system, but a de facto netting of dollar trade whereby goods are still being priced in dollars, but settled in CNY. The aim here is to undermine dollar hegemony, but the Yuan cannot hope to replace the dollar’s global role.

Chinese President Xi Jinping also made headlines overnight by picking up the phone to Volodymyr Zelensky for the first time since the war began. Xi again sought to position China as an honest broker in peace talks, and in the process repair some of the damage done earlier in the week when a Chinese diplomat in Paris seemed to borrow Russian talking points on former Soviet Republics having no legal status. Zelensky held firm on his red line that “there can be no peace at the expense of territorial compromises”, so we’re still at an impasse. What’s the next move?

Joe Biden has certainly been making moves. Yesterday he welcomed South Korean President Yoon Suk-Yeol to Washington to reaffirm the alliance between the two countries. The pair announced that US nuclear submarines would conduct port visits to South Korea and that any attack on the South by the Kim regime would be met with overwhelming force by the United States. Biden was unequivocal:

“A North Korean attack against the US or its partners is unacceptable, and would result in the end of whatever regime took the action.”

“I have absolute authority, and sole authority, to launch a nuclear weapon.”

Biden has been busy shoring up a constellation of US alliances in the Western Pacific to counter Chinese dominance in the region. On that theme, Australia’s recently released Defence Strategic Review was praised by US Defence Secretary Lloyd Austin:

“The DSR demonstrates Australia’s commitment to being at the forefront of incorporating new capabilities for the Australian Defence Force to better enable Australia to meet regional and global challenges, as well as to our unbreakable alliance, which has never been stronger.”

This sounds impressive, but the DSR doesn’t actually include much new money for defence for at least another four years, and the strategy for warship acquisitions has been hived off to yet another review. Doubtless there will be further conversations on this when Prime Minister Albanese welcomes Biden to Sydney for the Quad meeting on May 24th. What moves will come of that?

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