US fiscal deficits back in the frame – Westpac

The bipartisan budget agreement reached last week has elevated long simmering US fiscal deficit concerns, suggests Richard Franulovich, Research Analyst at Westpac.

Key Quotes

“The new budget plan temporarily lifts automatic spending cuts that were put in place under the 2011 Budget Control Act, when Congress failed to reach a “grand bargain”. Automatic spending cuts were imposed along with caps on how much spending could rise going forward. Last week’s deal raises the budget caps by nearly $300bn in the next two years ($165bn in defence spending & $131bn in domestic programs) and includes $80bn in disaster relief offset by $100bn in revenue measures.”

“The agreement results in projected deficits of a trillion dollars in 2019 but projections for 2018 come close too. The US recorded a $665bn federal deficit last year (3.5% GDP). The CBO projects that the Republican tax plan will add $110bn to this year’s deficit (for a total deficit of 3.9% of GDP). The budget plan agreed last week adds an additional $150bn, putting this year’s deficit in excess of $900bn, or 4.6% of GDP.”

“Last week’s deal includes automatic cuts of $125bn in discretionary spending from 2020, when the deal expires, but Congress is unlikely to let large cuts go into effect during a Presidential election year. Assuming the two year deal is extended out over a decade US public debt will hit 105% of GDP according to calculations by the Committee for a Responsible Federal budget. As recently as June 2017, the CBO 10 year baseline projections were for US public debt to rise from 76.7% of GDP to 91.2% of GDP by 2027. The $1.5trn Republican tax cut pushed that up to 97.1% by 2027 and it is now on track to hit 105% of GDP, a much steeper trajectory than envisaged barely six months ago.”

“Does any of this matter for markets? Terms premiums embedded in bond yields rose last week, a sure sign that deficits have been pushing yields higher. The San Fran Fed’s term premium calculations (Adrian Crump & Moench) decompose US yields into a “term premium” and the expected path of short term rates over the same period (aka the “risk neutral yield”). So far in February 10yr yields have risen 15bp yet Fed hike expectations embedded in the 10yr yield have fallen 11.4bp. The rise in the 10yr yield so far in February has thus been more than fully accounted for by a higher term premium, the latter having risen +26.5bp, arguably entirely due to heightened US fiscal risks.”

“Beyond that both the US curve and the USD have a long history of co-movement with the US fiscal deficit too. The US curve typically steepens when deficits grow and vice versa. The USD has a positive relationship with the deficit too, falling when deficits expand and vice versa, though that has only been apparent since the early 1990s – prior to that the USD appears to have moved inversely with the deficit. Prior to the early 1990s higher rates off the back of larger deficits presumably assisted the USD but that no longer appears to have been the case since then.”