Listen, the GOP is all about fiscal rectitude, ok?
That’s the party line. Unless of course we’re talking about helping rich people get richer and emboldening corporate “citizens” to buy back more shares, in which case it’s more like: “Fuck fiscal discipline, let’s pass a deficit-funded tax cut!”
Just ask current OMB Director and former man who “really believed you can’t spend money you don’t have”, Mick Mulvaney, whose views on spending have “evolved” with the presidency.
See, previously, Mulvaney was a “budget hawk” and he’s trying his best to rekindle that fightin’ spirit, but it’s kinda hard when your boss forces you to go out and justify spending $30 million on a goddamn Third World-style military parade. For evidence of how hard a time Mick had with that, look no further than this classic image from the moment when he was forced to explain the cost of the parade:
“Work for Donald Trump, they said. It’s not going to be as bad as you think, they said.”
Well anyway, fiscal discipline has gone out the window for Republicans because the bottom line is that it’s difficult to reconcile with Trump’s populist #MAGA mantra, implicit in which is a kind of deliberate ambiguity that gives him a license to do whatever the hell he feels like in order to restore American “greatness” despite not being able to say, definitively, what achieving “greatness” would entail.
Because you can’t nail down exactly what “greatness” means, Trump’s platform requires a blank check and because Republicans control the government, they’re the ones who have to sign it, a truly humiliating scenario that they should have seen coming given that Trump’s campaign promises were inherently open-ended.
So now here we are, with the deficit set to balloon and Treasury issuance approximating a goddamn deluge in order to finance this lunatic plunge into late-cycle fiscal stimulus. This is, according to almost every estimate, a road to fiscal ruin or at the very least, a road to Italy, which I guess is appropriate given the populist turn the government has taken there over the past two months.
I’m not going to rehash this entire discussion at length here. If you’re interested and haven’t heard enough to convince you yet, you can check out the following posts that cite multiple sources including Credit Suisse, SocGen, Goldman, BofAML, and on and on:
- Goldman Warns On U.S. Fiscal Policy: ‘We Are Heading Into Uncharted Territory’
- ‘Is Nobody Gonna Tell Him?’ MAGA And The Pedal To The Metal Economy
- ‘This Is Poorly-Timed’: Credit Suisse Ups Rate Hike Forecast Amid Budget Boondoggle
- Albert Edwards: ‘Trump’s Grotesquely Ill-Timed Stimulus Will Be Trigger For Market Implosion, Recession’
Well speaking of Goldman, they’re out with a new piece on budget deficits and interest rates and while that sounds like it’s all kinds of boring, you’re reminded that thanks to Trump, it’s actually not boring anymore – “the ratings are tremendous”.
Because what he’s doing here isn’t just anomalous in terms of when in the cycle he’s implementing expansionary fiscal stimulus. It’s also dangerous because it comes as the Fed is attempting to wind down the balance sheet (read: remove their support for the market).
So what you’ve got here is a deluge of supply against a less favorable demand technical and while that might be ok for the time being thanks to the myriad reasons why the U.S. long end is likely to find sponsorship in the near-term (safe haven bids tied to intermittent risk-off episodes, the steady dollar, the yield pickup hedging costs notwithstanding, the supply of convexity to rates that creates a self-feeding dynamic thanks to the vol. dampening effect, etc.), it raises questions about long-term sustainability.
You might recall that Goldman’s previous work on this included the following rather amusing chart that illustrates how the U.S. is literally headed into uncharted territory:
Well in their latest note on the topic, dated Saturday, the bank attempts to quantify the impact on rates from increases in the budget deficit. They begin by reminding you what’s going on here:
US budget deficits are on an unusual path. While historical patterns suggest that the US would usually be running a modest budget surplus at this point in the business cycle (Exhibit 1), the federal budget is instead on course for a deficit of 5.5% of GDP in FY2021. The sizeable demand boost provided by the recent deficit-increasing tax cuts and spending cap increases at a time when the economy is already somewhat beyond full employment is a striking departure from historical norms that is likely to contribute to further overheating this year and next and tighter monetary policy in response.
And see that last bit represents a real problem for risk assets the world over. Piling this kind of stimulus atop an economy operating at (or at least near) full employment risks stoking inflation and that, in turn, could entail more aggressive measures from the Fed to tighten policy. That means higher real rates and near- to medium-term support for the dollar and less favorable $ liquidity conditions, all of which could spell trouble for risk assets.
Additionally, it’s not like the U.S. can afford this right now. “The unusual increase in the deficit is even more surprising because it comes at a time when the federal debt-to-GDP ratio is already approaching historical highs,” Goldman goes on to remind you, adding that “the resulting increase in Treasury issuance will require the public to absorb considerably more government debt in coming years.”
Yes, it “will require the public to absorb considerably more government debt in coming years” and as a reminder, that bid is price sensitive. That, as opposed to the price insensitive bid from central banks. The question here isn’t whether the market will clear, but rather at what price. Here’s Goldman:
Fiscal easing could therefore raise long-term interest rates via two primary channels. The first channel is monetary policy, the flow-through from higher expected policy rates in coming years to long-term rates. This channel is probably best captured by the change in the deficit as a measure of the boost to near-term aggregate demand. The second channel is a supply effect, an increase in the premium required by markets to absorb a larger supply of debt.
The bank uses three approaches to estimate the effect of deficits on rates. The first two methods are pretty standard in the sense that they rely on the literature and historical evidence, so I’ll just give you the two bullet points from Goldman’s conclusions in the section that use Laubach’s research and a related section:
- Our estimates for the full sample starting in 1976 imply that a 1pp increase in the long-run deficit-to-GDP ratio raises the 5-year forward 10-year Treasury rate by 20bp.
- Our full sample estimate implies that a 1pp increase in the expected deficit-to-GDP ratio gradually raises both forecasted and actual 10-year yields by about 10bp. To test the possibility that the effect of deficits on interest rates varies with the state of the business cycle, we divide the sample into periods when the economy is at or beyond full employment and periods when it is below full employment. We find that a 1pp increase in the expected deficit-to-GDP ratio gradually raises forecasted and actual 10-year yields by about 20bp when the economy is at or beyond full employment, and we view this estimate as most relevant to the current US situation.
The third approach is more interesting if only because they use PredictIt odds as they evolved last year in the lead up to the passage of tax reform.
There’s a lot of explaining and caveats involved, but when you boil it down the basics, here’s what Goldman did:
Specifically, we use daily implied probabilities of a cut in the corporate tax rate from PredictIt. The implied probability initially declined in the spring and summer of 2017 and then moved up again in the fall (Exhibit 5, left panel). We regress changes in 10-year Treasury yields on changes in these implied odds of corporate tax reform. To capture the effect of economic news unrelated to the tax bill, we control for changes in our MAP surprise index and in the 10-year Bund yield.
Here’s where it gets funny. Goldman goes ahead and assumes that the people using PredictIt were well apprised of what the tax bill would mean for the deficit. And while I guess I could be reading it wrong, it also seems like Goldman implicitly posits a scenario where either rates traders are paying attention to PredictIt, PredictIt participants are also rates traders, or, even funnier, both.
Whatever the case, their conclusion from that section is as follows:
Using these two samples, we estimate that an increase in the probability from 0% to 100% implies an increase in long-run rates of 10-30bp. Our estimates imply that 1pp increase in the deficit-to-GDP ratio increases 10-year rates by 15-50bp, with a central estimate of 35bp.
Ok, so who cares? Well, you do, actually. Because to the extent you’ve been fretting over what the effect of rising 10Y yields is likely to be on stocks and/or on risk assets more generally (like say, if you see a parallel between rising U.S. rates and the EM selloff), well then all of the above is extremely relevant.
Finally, all of this raises a very interesting long-run question. What happens in the event the current situation causes the Fed to overtighten or, more simply, what happens when the expansion finally ends? That is, what happens when the U.S. runs into the next recession in the worst fiscal shape it’s ever been in and the Fed undercuts the dollar by cutting rates? It seems like it’s possible in that scenario that the sponsorship for the U.S. long end would disappear in a hurry leading to a rather nasty steepening episode and everything that comes with it.
“You will ride eternal, tacky and gold leaf”…