There was a saying in Chicago’s bond pits – back in the days when there was a physical trading floor populated with living, breathing traders – that bonds were the crop that never failed. While this was originally a WWII advertising slogan for American war bonds, its more contemporary meaning was that Washington could always be relied on to produce more IOUs to cover its inevitable deficits.
President Joe Biden’s first annual budget plans to spend $ 6 trillion in the next fiscal year, with multi-trillion dollar deficits on the horizon. It reminded the debt market of the endless supply of bonds it faces. It also highlights that Uncle Sam’s finances depend on today’s historically low interest rates, as do near-record stock prices and the burning housing market.
They’re all addicted to cheap loans.
The actual budget was released Friday afternoon, just before the three-day Memorial Day weekend and the start of the Congressional vacation. Timing is important, Goldman Sachs economist Alec Phillips observed earlier, suggesting it may attract less attention to the spending plan than what would be generated by a traditional Monday morning publication.
In reality, the proposal is “ambitious,” says Greg Valliere, the chief US strategist at
“Biden knows he can’t get all of this, but he wants to convince progressives that he’s on their side. He has to keep them happy, because they won’t like the inevitable compromises Biden will have to make with Manchin and the GOP, ”writes the longtime Washington observer in an email, referring to centrist Senator Joe Manchin. Democrat of West Virginia. , and the Republican opposition in the equally divided Senate.
Even so, there is likely less new to the $ 6 trillion plan than it looks, writes Phillips in a research note. Starting with the Congressional Budget Office’s base spending of $ 5.05 trillion for the year beginning October 1, the US bailout (the $ 1.9 trillion measure adopted this year) adds $ 529 billion. dollars in fiscal year 2022.
The White House has already sent Congress a request for $ 118 billion in additional discretionary spending, bringing the total to $ 5.7 trillion. The additional $ 300 billion likely reflects the effect of the roughly $ 4.4 trillion proposed by Biden in the US Jobs Plan and the US Family Plan.
What caught the stock market’s attention was the Wall Street Journal report that the budget assumes capital gains tax would be increased retroactively to April 28. The revised levy would increase the federal long-term capital gains rate for people earning more than $ 1 million per year. at the same rate as ordinary income.
AFP would also raise the top tax bracket to 39.6%, where it stood before the 2017 Tax Cuts and Jobs Act lowered it to 37%. If the 3.8% supplement for the Affordable Care Act were added, the new capital gains rate for $ 1 million wage earners would be 43.4%, up sharply from the 23.8% % current.
As this column noted a few weeks ago, raising the capital gains tax is not a done deal. And the effective date is likely to be the subject of intense lobbying, writes Brian Gardner, chief Washington policy strategist at Stifel. Most of the other tax measures would probably come into force on January 1, he adds in a customer note.
Gardner thinks there’s a good chance Congress will agree to a capital gains tax hike, but a smaller one than the one proposed by the White House. Twenty-eight percent – the rate in effect from 1986 to 1997 – seems more likely, he adds, a view shared by some other observers. Given that only 25% of US stocks are held by investors subject to the levy, the impact of a moderate increase would likely be mitigated. (The rest of the U.S. stocks are held by non-U.S. pension funds, foundations, and investors.)
As the bond market wary of Biden’s budget plans, which would bring federal debt to 117% of gross domestic product by the end of the decade, Treasury Secretary Janet Yellen is downplaying the risks.
She told the House supply subcommittee on Thursday that the administration’s proposals were fiscally responsible because, in part, the real burden on interest rates is negative. Indeed, the yield on long-term Treasury securities of 1.60% is below the inflation target of 2%. The real cost of interest is a better measure of the debt burden than the debt-to-GDP ratio, argues Yellen. (As measured by 10-year Inflation-Protected Treasury Securities, or TIPS, the real yield for this maturity is less 0.84%.)
But that’s only because of the current extraordinarily low negative real interest rates, retorts Lawrence Summers, the former Treasury Secretary in the Clinton administration and a vocal critic of the budget plans of fellow Democrats. The Federal Reserve has set its short-term rate target near 0% while keeping a lid on long-term rates with its massive purchases of securities, he said in a video meeting on Thursday. ‘Economic Club of New York.
Summers reiterated that Biden’s spending plan risks “overheating” the economy, which he says will return to trend growth at full capacity by the end of the summer. At the same time, “monetary and fiscal accelerators are driven to the ground,” which could trigger an inflationary surge that would be more than transient, as Fed officials insist current price hikes are. And while Biden’s plans contemplate tax hikes, Summers said the levies would be “delayed” and would not address the risk of overheating in the short term.
But at the end of the day, the flaw in Biden’s budget is that it rests on what Valliere calls “a very shaky premise” that debt servicing costs can be contained. In fact, he argues, the demographics will push the national debt above $ 30 trillion as baby boomers retire, increasing spending on Social Security and Medicare.
“So it seems the only way to deal with this spending frenzy is for interest rates to stay unusually low,” Vallière wrote in a client note. By keeping its short-term rate target low, perhaps close to 0%, until 2023, the Fed under Jerome Powell has been prepared to “go big,” he continues, aiming for “maximum employment” and inflation exceeding its putative 2% target.
But if the economy overheats due to supercharged monetary and fiscal policies, as Summers expects, the question is: when will the market’s appetite for the bumper crop of bonds be sated?
“It’s the loophole in Biden’s budget,” says Vallière. “If the Fed allows the economy to overheat and spending continues to rise, interest rates will inevitably have to rise; the question is whether they will increase moderately or increase dramatically.
At the start of the Clinton era, Democratic Councilor James Carville made the famous observation: “I thought if there was a reincarnation, I wanted to come back as president or pope or as a baseball hitter. But now I would like to come back as a bond market. You can intimidate anyone.
This observation can take on new life in a Biden administration.
For its part, the stock market has shown no concerns about the country’s long-term fiscal health. The major indices have all risen over the past week, although the Nasdaq Composite’s gains were not enough to put the tech-dominated gauge in the positive column for May.
According to a report by Bank of America’s strategy team, led by Michael Hartnett, large flows in equity funds continue, last week’s $ 17.9 billion bringing the 2021 total to $ 512 billion. of dollars. In fact, the amount the bank’s own private clients invested in stocks was the fourth largest since 2012. Such signs of exuberance make the antennas of opponents tremble.
Ditto for some anecdotes on the rise of speculative interest among investors. In a note to a client, Jason DeSena Trennert, director of Strategas Investment, said that an old friend from his hometown of Long Island texted him in mid-April to tell him that he was “thinking about buying crypto, is it risky? ” It was just when Bitcoin hit $ 62,284. By the time Trennert’s rating was released on Friday, it had fallen 38%.
His friend’s question may have ringed the proverbial bell, like previous ones that signaled highs for biotech, airlines and Sirius satellite radio in 2000, when the Nasdaq bubble was about to burst.
The air has also come out of other sectors swollen with exuberance, rational or not, and free Fed money. Based on their recent highs, Trennert notes, the IPOX SPAC index fell 24.5%; the
the exchange-traded fund (ticker: TAN) was down 35%; the
ETF (ARKK) fell 28%; and
(TSLA) had slipped 29%. Restoring some calm to such speculative sectors would help the sustainability of the bull market, he concludes.
Instead, the frenzy returned to so-called memes stocks last week, with
(GME) jumping 25.6% and
(AMC) up 114.7%. These names are sometimes seen as outliers and even as an asset class on their own. But their inflated values have pushed these previously insignificant stocks into the mainstream of the market.
GameStop is now the second largest holding company and AMC the eighth
iShares Russell 2000
ETF (IWM), which tracks the most popular indicator of small-cap stocks believed to represent major US industries.
All the stars have lined up for the equity market, including maximum monetary and fiscal stimulus; spike in economic growth, with manufacturing and service purchasing managers’ indices at record highs; plus benign financial barometers, with historically low high yield credit spreads and moderate volatility, as indicated in the
Cboe volatility index,
or VIX, in adolescents. These indicators suggest that the easy money has been made, writes Anastasios Avgeriou, BCA’s US stock strategist. “Our feeling is that the next 10% of [S&P 500] is lower (close to 3800) than higher, ”he concludes.
Investors would do well to take some profits to raise cash for better opportunities later this summer.
Write to Randall W. Forsyth at [email protected]