U.S. Budget Deficit Rising (Should be Falling); Impact on Borrowing and Interest Rates

by the Curmudgeon

Introduction:

Strong jobs report, initial unemployment claims at 49 year low, 2^nd quarter GDP at 4.1% with many previous quarters revised up. The Labor Department’s broadest measure of unemployment, which includes workers forced to take part-time jobs because full-time positions are unavailable, fell to 7.5 percent in July, the lowest since 2001. Indeed, the U.S. economy is in the midst of the longest monthly streak of job growth in history.

One would think the federal budget deficit should be shrinking with such strong economic numbers. WRONG!

In its latest budget review, the Congressional Budget Office (CBO) states:

“The U.S. federal budget deficit was $607 billion for the first nine months of fiscal year 2018. That was $84 billion more than the shortfall recorded during the same period last year. The CBO estimates that the deficit for fiscal year 2018 (which ends on September 30, 2018) would total $793 billion, about $127 billion more than the 2017 shortfall. “

The CBO is projecting that the deficit will keep rising to $973 billion (4.6% of projected GDP) in fiscal 2019 and just over $1 trillion (also 4.6% of GDP) in fiscal 2020. By 2028 CBO projects that the budget deficit will hit $1.5 trillion by 2028, resulting in a cumulative deficit of $12.4 trillion over the 10-year period from 2019 to 2028.

The Office of Management and Budget said this month that it had revised its forecasts from earlier this year to account for nearly $1 trillion of additional debt over the next decade — on average, almost $100 billion more a year in deficits.

The increased budget deficits are largely due to last December’s GOP tax bill, which introduced a standard corporate income tax rate of 21%, down from a high of 35% (top rate which few companies paid) and allowed companies to immediately deduct many new investments. As companies operate with lower taxes and a greater ability to reduce what they owe, the federal government is receiving far less than it would have before the overhaul.

The Trump administration had said that the tax cuts would pay for themselves by generating increased revenue from faster economic growth, but the White House has acknowledged in recent weeks that the deficit is growing faster than it had expected. This is not at all happening!

“That’s part of the equation people haven’t been talking about,” said Ian Lyngen, head of U.S. government bond strategy at BMO Capital Markets. “The notion that tax reforms are going to pay for themselves is being tested right now.” Really?

Corporate tax-rate reductions are restraining federal government revenue, because less tax is being generated for every dollar of household and business income earned. The Treasury Department said last month that tax receipts fell 7% in June from the same month a year ago, including a 33% drop in gross corporate taxes.

Worse, the Treasury department data indicated that from January to June this year, corporate tax payments fell by a third from the same period a year ago. The drop nearly reached a 75-year low as a share of the economy, according to federal data as indicated in this graphic:

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U.S. Trade Deficit Increases- Who Cares?

Pundits rarely talk about the ballooning U.S. trade deficit, yet it still has to be financed (largely by foreign purchases of U.S. Treasury securities and foreign direct investment). The U.S. trade deficit in goods and services expanded in June at the fastest rate since November 2016. It increased 7.3% in June from the previous month to a seasonally adjusted $46.35 billion, the Commerce Department said Friday.

The U.S. economy has run overall trade deficits for decades, during both economic expansions and recessions. Many argue that trade deficits imply that Americans are living beyond their means and accumulating too much debt (which at some point in time must be repaid or defaulted on).

Budget Deficit Impact on U.S. Treasury Auctions and Interest Rates:

The WSJ reported Thursday August 2^nd:

“Rising federal budget deficits are boosting the U.S. Treasury’s borrowing and could restrain a fast-growing economy as the cost of credit rises, too.”

The Journal article notes that Treasury Department would increase auctions of U.S. debt by an additional $30 billion over the next three months. That included higher sales of two-year, three-year and five-year notes and the introduction of a new short-term security with a two-month maturity. In all, the Treasury plans to borrow $329 billion from July through September—up $56 billion from the agency’s April estimate—in addition to $440 billion in October through December. The figures are 63% higher than what the Treasury borrowed during the same six-month period last year.

In addition to the moves with the notes and bonds, Treasury said it will consider increasing the auction amount for its Treasury Inflation Protected Securities.

"Treasury will assess the need to make further adjustments to auction sizes at the next Quarterly Refunding in November based on projections of the fiscal outlook at that time," the department said in a statement.

The U.S. national debt is officially at $21.3 trillion, having risen about $800 billion in 2018. That debt is financed through additional U.S. government Treasury auctions. Fed officials have privately discussed the debt issue, and Chairman Jerome Powell on multiple occasions has said the fiscal trajectory is "unsustainable."

The size of U.S. government borrowing in coming years is hanging over the bond market. In addition to the increased spending forecast for the federal government, there is concern about lower tax revenue. Many analysts and investors expect these developments will ultimately lead to higher borrowing costs for the U.S. government.

“Everyone thinks we won’t have a problem financing trillion-dollar deficits until we have one,” said Brian Edmonds, head of Treasury trading at Cantor Fitzgerald LP.

The effect of increased debt levels “depends on how many people want to buy your debt,” said Don Ellenberger, head of multi asset strategies at Federated Investors.

The U.S. has benefited from “safe haven” demand for Treasury’s from Europe and Asia, which has kept borrowing costs relatively low. Till now. What happens next?

Questions to Ponder, Things of the Past or No Worries?

· Whatever happened to the bond market vigilantes? [Bond market institutional investor who protests monetary or fiscal policies he considers inflationary by selling bonds, thus increasing yields.]

· And what about the crowding out effect [Increased U.S. treasury auctions would crowd out private sector borrowing].

· How can the U.S. dollar be seen as a safe haven/flight to quality investment when it's really a flight to junk? That’s considering the spiraling U.S. budget deficits and increased national debt that must be financed by an ever increasing supply of Treasury securities.

· If the budget deficit is rising rapidly during strong economic growth with low unemployment/jobless claims, what will happen to deficit when there's a severe recession? Government outlays always increase during a recession while tax revenues plummet as profits decline or turn into losses.

· If no recession, but intermediate to long term interest rates return to their historical average with a real yield 3% above the nominal inflation rate, will the government be able to finance the increased deficits/national debt at those significantly higher rates? If not, will there be a flight from the U.S. dollar as a “safe haven” for foreign money?

GDP Growth Not as Advertised, by John Williams of Shadowstats:

Guest commentator John Williams argues that the lack of U.S. deficit improvement reflects a less-than booming economy with strong GDP not confirmed by other metrics. Here’s his unedited remarks:

Purportedly, all is booming in the U.S. economy these days, yet there are some reasons to be a bit skeptical. Removing the effects of inflation, second-quarter 2018 real Gross Domestic Product (GDP), the broadest measure of U.S. activity, stood 17.4% above its pre-Great Recession peak activity at the end of 2007. After fourth-quarter 2007, the GDP began is worst tumble since the Great Depression. It hit bottom in 2009, recovered its pre-recession peak in 2011 and has been expanding happily ever since.

The problem is that no other major “hard” economic measure confirms that margin of boom, and some industries, such as manufacturing and housing/construction, still are down meaningfully, never having recovered their pre-recession highs.

If the GDP is soaring, so too should be the number of employed people supporting it. The economy is up 17.4% from its prior high, yet the level of civilian employment is up by just 6.4% in the same period? The strongest conventional economic measure other than the GDP appears to be real retail sales, up by 8.8%, but that is bloated, being deflated by understated CPI inflation.

“Soft” economic measures such as growth in “intellectual property,” “legal and brokerage services” and “health care services” are higher, but they are not measured meaningfully and generally do not lead economic activity.

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End Quote from the Peter G. Peterson Foundation:

Federal debt is already at its highest level since 1950 and is projected to nearly equal the size of our economy by 2028. Debt at such levels is unsustainable.

Unless policymakers act, CBO concludes that rising debt could jeopardize long-term economic growth, crowd out critical investments, reduce policymakers’ flexibility to respond to unforeseen events, and raise the risk of a fiscal crisis.

This dangerous path of federal debt remains a critical issue for our economy, and changes to spending and tax policies are necessary to put the nation on a sustainable path.

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Good luck and till next time…

The Curmudgeon
ajwdct@gmail.com

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Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.

Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies. Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.

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