Insights from a Former Treasury Secretary: The U.S. Fiscal Policy Problem and Its Impact on Markets

A couple of the Wealhouse team members were at a dinner last night with a prominent former Treasury Secretary. Among multiple topics, the highlight was the discussion on fiscal policy. The guest notably emphasized “I don’t know where interest rates are going but I do know that the U.S. has a huge fiscal policy problem that will ultimately end badly if not resolved”.

Currently, the U.S. has been increasing their fiscal deficit exponentially in a bid to please political parties and prop up the economy. With that said, what are the repercussions of such an unsustainable trend? As seen in the chart below, the current national debt is almost 100% of the entire U.S. economic GDP. Looking into the future, the Congressional Budget Office (CBO) states: “The national debt could rise to 172 percent of gross domestic product (GDP) by 2054 if current laws remain the same. That level of debt would far exceed the 50-year historical average of 47 percent of GDP.”

The reaction of U.S Treasury bond yields following this week’s Fed policy decision gave us some insight into the bumpy future path of interest rates. On Wednesday, the Federal reserve cut 50 bps but government bond yields actually rose by 3-5 bps. This adverse market reaction is both a function of aggressive cuts already priced into the market but also the build up of Treasury bond issuance in the coming months to fund the anticipated wall of fiscal spending.

Separately, we think the upcoming U.S election is likely to pressure budget deficits higher in the coming years, no matter which party wins. Both Democrats and Republicans have put forward bills that include heavy spending plans, namely in infrastructure, remilitarization and healthcare.

JPMorgan CEO Jamie Dimon is one of the most prominent figureheads voicing skepticism for a soft landing and lower interest rates due to similar considerations mentioned above. In this year’s letter to shareholders, Mr. Dimon wrote: “All of the following factors appear to be inflationary: ongoing fiscal spending, remilitarization of the world, restructuring of global trade, capital needs of the new green economy, and possibly higher energy costs.”

As a vast amount of Treasury supply is anticipated to hit the market in 2024 and 2025, we believe this could push U.S. 10-year yields potentially back to the 4% range if not dealt with properly and swiftly. This potential shift in higher yields despite entering a monetary easing cycle could have major consequences for both domestic and global economies. The former Treasury Secretary capped off the night by saying “Fasten your seatbelts, it’s going to be a bumpy ride”. The fiscal trajectory validates the need for active long/short strategies as it is not without doubt that traditional equity and bond market relationships can expect to be repeated in this upcoming cycle