Agitation under the surface

Markets

US stocks were treading water on Monday, oscillating on either side of flat, amidst little news to trade on as the 1Q23 earnings season winds down and ahead of important macro data later in the week.

At first glance, markets appear to be assuming a more serene approach as they contemplate the impact of emerging tail risk and prepare for more data later this week. However, a look beneath the surface reveals more distress than that first glance might portend. 

This year's debt ceiling debate in Congress entered a new phase last week after Treasury Secretary Yellen warned officials that the US could default as soon as June 1. 

The White House will meet with Congressional leaders on Tuesday to start negotiations. Expect noisy rock-the-boat-type headlines and political posturing over the next few weeks. 

We will likely see a continuous escalation of concerns, with all sides trying to apply pressure to drive a compromise. And with very little in the way of a clear path to a solution, US stocks risk hitting an abbreviated Washington DC downdraft.

After a sharp repricing last week, June maturities are now the cheapest sector in the bell curve. Money market funds and international investors sat out on the bill auction with a June 6 maturity, pushing the 4-week bill rate to a record 5.84%.

Finally, while today and tomorrow are relatively light on the 'scheduled news' front, the back half of the week brings quite a bit of new news, including two new inflation readings: April CPI and PPI on Wednesday and Thursday.

Oil

Crude oil -- which sold off last sharply last week on the back of bank stress -- moved higher on Monday, perhaps reflecting lessons from the early March banking sector's overblown conditions.

Still, prices are off interday peaks in line with SPDR S&P Regional Banking ETF trading lower, suggesting oil traders are still looking over their shoulders at bank shares.

Ongoing bank stress, China's industrial weakness, falling diesel margins, concerns around elevated oil supply in Russia and Iran, and fears of limited OPEC compliance to cuts remain valid bearish counterpoints to the bullish thesis.

Forex

The latest SLOOS data showed a more modest tightening of lending standards than feared; hence the US dollar recovered slightly while overall risk sentiment remained on its narrow path to recovery.

Yields on both 2-year and 10-year US Treasuries are increasing, perhaps indicative of increasing comfort with a Fed Pause versus a rate cut scenario.

It would be an unusual policy decision for the Fed to ease this year against tight labour markets. And given last Friday's strong Nonfarm Payrolls reading, ultra-low unemployment rate, plus recent inflation pressures, even the most ardent Fed critic should concede the Fed will likely be cautious about easing too soon.

The positive European story and another ECB rate hike are mainly in the price. So, negative dollar drivers will have to kick in for the next move higher in EURUSD. Whereas the risk for the EURO is that the ECB underdelivers, given they seldom, if ever, go full-on hawk on their own

Currently, FX markets are dominated by banking and debt ceiling-induced recession fears, which drives concentrated hedging demand in gold, JPY and CHF.

But for the Euro to take flight, there must be definitive evidence that US inflation is coming down, allowing the yield curve to steepen more. But ultimately, Chair Powell would need to validate the market rate cut pricing by adjusting the Fed communications settings to dovish.