By: Stash Graham
On the back of increased government spending and a reduction in tax receipts over the last few years, the US budget deficit has grown by 26 percent, to almost $1 trillion for year-end 2019. The Congressional Budget Office (CBO) and the financial analyst community project the deficit will grow to $1.2 trillion by the end of 2020. With projected further historic deficit growth, it is important to investigate how this impacts financial markets and asset prices.
First, the continued growth in US Treasury issuance to fund these deficits puts pressure on liquidity. When US Treasuries get auctioned off into financial markets, cash and reserves are removed from the system (since you need to pay for the Treasuries). Second, the growing gap between tax receipts (income) and government spending (expense) is creating conversation about how much the government can borrow and spend without driving up borrowing costs (interest rates on US Treasuries) or inflation.
To the first point, a couple of months ago, you might recall seeing a spike in interest rates within the “repo market.” A shortage of accessible reserves prevented financial institutions with high quality collateral from getting affordable borrowing rates. A large Treasury auction was one of a few reasons why we saw the lack of reserves to provide liquidity in the lending markets. The Federal Reserve since then has had to come in and provide around $215 billion in liquidity and counting. This is a part of the Federal Reserve’s job, even though they have not needed to provide this function in about nine years.
This raises the question of what would happen if the economic cycle does end and the economy contracts. If that were to happen, the deficit will expand materially as it normally does during recessive periods and the US Treasury would increase the amount of Treasuries that would need to be auctioned off. With a projected deficit north of $1 trillion in the next 12 months, the Federal Reserve will need to be ready for some heavy buying. We have already witnessed some growth in the Fed’s balance sheet over the last 60 days which signifies a reversal in monetary policy from the last three-four years. As we have previously stated over the past few months, December will be an interesting month for the repo markets as banks and primary dealers will be less likely to lend as they try to “beautify” their balance sheets for year-end regulatory check-ups. On December 2, the investment community witnessed the Federal Reserve’s second 42-day term repo operation in a week to be oversubscribed by at least $20 billion. The thirst for year-end cash is real and we do not see it ending anytime soon. Believe me when I say that a large bank, like JP Morgan Chase, would love the 10% overnight rate[1] that we saw in September in the repo market.
Covering the second point regarding the growing tax receipt/government spending gap, over the last two years, the US government budget deficit has grown and interest rates have decreased. This is an abnormal event that can be attributed to the central banks around the world cutting their borrowing rates and restarting bouts of Quantitative Easing or QE-like functions. Historically, as deficits materially grow, interest rates will start to rise as the investing public becomes concerned that the amount of government liabilities has become unsound. This creates a situation of lacking demand versus the growing supply. In the fixed income world, these two variables produce higher yields. When interest rates rise, what happens to financial asset prices? Think of interest rates as gravity, when interest rates are low, financial asset prices can gravitate higher. The US Treasury interest rates are the risk-free rates in financial asset price discounting exercises. If coupon rates between two different asset classes like the US Treasury Bond and “ABC Company” common stock are available for investment, the “risk-free” Treasury will be chosen as the value being proposed by the US Treasury, as it is is much more attractive. Since the coupon rates are close, the lower risk of the US Treasury will make this position more attractive than the higher risk alternative. The increasing interest rates offered by lower risk instruments, like the US Treasury, will draw capital away from higher risk positions like common stock, preferred stock and corporate bonds. This process is systematic in nature and bears watching. In summation, all financial assets are priced and valued off US Treasury rates.
One final point to address is, does the Federal Reserve printing press generate inflation? No, not in the economy, but in financial asset prices. When the Federal Reserve runs a Quantitative Easing program, the central bank purchases the US Treasuries, not the investing public. The supply of US Treasuries in circulation for the investment community does not grow (prevents the supply/demand dynamic talked about earlier). Instead, QE-related Treasury auctions end up on the Federal Reserve’s balance sheet. The proceeds of QE purchases end up in the reserves of some of the largest banks in the country for free. Now what happens to these newly found reserves? This generally encourages for yield-seeking investment speculation. If you look back earlier during this economic cycle when we had QE 1, 2 and 3, you will see that during “QE3” (at the end of 2012 into 2013), while the economy grew by 1.8 percent, the S&P 500 was higher by 32 percent.