Domestic Bonds

Tax hikes alone won’t pay for Biden’s budget plan. The bond market will have to take over.


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 culture that never failed. While this was originally a WWII advertising slogan for US war bonds, its more contemporary meaning was that Washington could always count on more IDs to cover its inevitable deficits.

President Joe Biden’s first annual budget plans to spend $ 6 trillion in the next fiscal year, with $ 1 trillion in deficits on the horizon. It reminded the debt market of the endless supply of bonds it faces. He also points out that Uncle Sam’s finances depend on today’s historically low interest rates, as do near-record stock prices and the boiling housing market.

They’re all addicted to cheap loans.

The actual budget was released on Friday afternoon, just before the three-day Memorial Day weekend and the start of parliamentary recess. The timing is important, observed Goldman Sachs economist Alec Phillips, suggesting it may draw 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, chief US strategist of

AGF Investments.

“Biden knows he can’t get all of this stuff, 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 in West Virginia, and the Republican opposition in the Senate equally divided.

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 Biden proposed in the US Jobs Plan and the US Family Plan.

What caught the attention of the stock market is The Wall Street Journal report that the budget assumes that the capital gains tax would be increased retroactively to April 28. The revised levy would push up the federal long-term capital gains rate for individuals who earn more than $ 1 million annually at the same rate as ordinary income.

AFP would also increase the top tax bracket to 39.6%, where it was before the 2017 tax cuts and jobs law 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 23.8%. % current.

As this column noted a few weeks ago, the capital gains tax hike is not done. 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 take effect on January 1, he adds in a customer note.

Gardner thinks there’s a good chance Congress will agree to a capital gains tax increase, 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. Since only 25% of US stocks are held by taxable investors, the impact of a moderate increase would likely be mitigated. (The rest of the U.S. stocks are held by non-U.S. Retirement funds, endowments, 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 playing down the risks.

She told the House supply subcommittee on Thursday that the administration’s proposals were financially responsible because, in part, the real interest rate burden is negative. Indeed, the yield on long-term Treasury securities of 1.60% is below the inflation target of 2%. The real interest cost 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 extremely low negative real interest rates, argues Lawrence Summers, former Treasury secretary in the Clinton administration and openly criticizing 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 being pushed to the floor,” which could trigger an inflationary surge that would be more than transient, as Fed officials insist on current price hikes. And while Biden’s plans contemplate tax hikes, Summers said the levies would be “overburdened” and would not address the risk of overheating in the short term.

But at the end of the day, Biden’s budget flaw is that it rests on what Valliere calls “a very shaky premise” that debt servicing costs can be contained. In fact, he claims, demographics will drive the national debt above $ 30 trillion as baby boomers retire, thus 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 abnormally low,” Valliere 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 ready 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?

“This is the flaw 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 considerably. “

Back in the early days of the Clinton era, Democratic Councilor James Carville famous: “I used to think that if there was reincarnation, I wanted to come back as president or pope or as a .400 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 place the tech-dominated gauge in the plus column for May.

Massive inflows into equity funds continue, with last week’s $ 17.9 billion bringing the 2021 total to $ 512 billion, according to a report by Bank of America’s strategy team, led by Michael Hartnett. In fact, the amount that the bank’s own private clients invested in stocks was the fourth since 2012. Such signs of exuberance float the antennas of annoyances.

Ditto for some anecdotes on the growing speculative interest of investors. In a client note, Jason DeSena Trennert, director of Strategas Investment, said that an old pal from his hometown of Long Island texted him in mid-April to tell him that he was “considering buying crypto. , is it risky? ” It was right when Bitcoin hit $ 62,284. By the time Trennert’s rating was released on Friday, it had fallen 38%.

His friend’s question might 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 is also out of other sectors swollen by exuberance, rational or not, and free Fed money. Based on their recent highs, Trennert notes, the IPOX SPAC index was down 24.5%; the

Invesco Solar

the exchange traded fund (ticker: TAN) lost 35%; the

ARK innovation

ETF (ARKK) was down 28%; and

You’re here

(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) jumped 25.6% and

AMC Entertainment

(AMC) up 114.7%. These names are sometimes seen as outliers and even an asset class in themselves. But their inflated values ​​have pushed these previously insignificant shares 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 measure of small-cap stocks believed to represent traditional US industries.

All the stars lined up on the stock market, including maximum monetary and fiscal stimulus; spike in economic growth, with purchasing managers’ indices for manufacturing and services at record highs; as well as benign financial barometers, with historically low high yield credit spreads and moderate volatility, as indicated by 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% move in the [S&P 500] is lower (close to 3800) rather 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]