Tax Bill & Shrinkage Tantrum

The Congressional Budget Office (CBO) scoring of the tax bill was released at 8:49 PM on Friday night, and this link will take you to it: https://www.cbo.gov/system/files/115th-congress-2017-2018/costestimate/53362-summarysenatereconciliation.pdf. The title of this one-page document is a mouthful: “Summary of the Deficit Effects of a Bill to Provide for Reconciliation Pursuant to the Concurrent Resolution on the Budget for Fiscal Year 2018, As Filed by the Senate on December 1, 2017.” The numbers here are critically important, though there may be some additional financial adjustments, given that the Senate debate ended in the early hours of Saturday morning and given that the Senate-version text has handwritten notes on the legislation that have not been read (let alone scored) by CBO. We note that some commentators believe the notes are not even legible.

Anyway, this is our political system, like it or not. As Churchill observed in the House of Commons in 1947, “Indeed it has been said that democracy is the worst form of government, except for all those other forms that have been tried from time to time.…” Sir Winston did not originate the line, but he did make it famous. Its origin is subject to debate. I personally verified that factoid with the chief archivist of the Churchill Library.

The Senate version of the tax bill (whatever it is) and the House version (which we have been able to read) will now go to a conference for the next round in this political dogfight. Our view remains that there will be a final tax bill and that Trump will sign it no matter what the final bill looks like.

We will set aside comments on the detailed tax changes, as they have already been discussed and are not final until we get a House-Senate conference version.

Let’s get to the deficit.

We are using the CBO scoring detailed in the link as a guide. Remember that budget and deficit projections have a wide margin of error. They are based on lots of assumptions. About the only thing we really know about those assumptions is that they are wrong on the day you make them. The whole idea is to get the theme right and to try to get close to what the final numbers will be.

Here are the themes.

The additional federal deficit that is expected to occur as a result of this tax bill is added to the baseline of projected deficits. Thus we can combine the baseline we know with the CBO scoring we see, and that leads us to an estimate of total deficit over the next ten years. We know that the interest component and other components (like transfer payments) are fixed as legal obligations and are non-discretionary. The United States will pay the interest on its debt no matter what the rate is. We can project that rate, but we are guessing because we do not know what rates will be set by the Federal Reserve during the next decade.

We do not even know what the rates will be next year. We can only make educated guesses at that. About the only thing we know of long-term interest rate forecasts is they have proven consistently wrong.

We expect that the cumulative effect of these tax bill changes will take the deficit to 100% of the GDP of the nation in the “out years.” Which year that happens is irrelevant! It is the trend that counts. And that trend is up and will be accelerating after the tax bill passes and starts to be phased in.

In 2018 the impact will be small and not meaningfully felt by markets. In 2019 the impact will start to rise, and markets may be absorbing $700–800 billion of incremental new federal debt issuance at the same time the Federal Reserve is disgorging hundreds of billions in federally guaranteed holdings while the Fed also shrinks its balance sheet. Note that the Fed will not be selling: It just won’t buy as much replacement debt when maturities occur.

We have enough information from Fed-official testimony and Fed releases to estimate that the Fed will shrink its balance sheet by a total of about $1 trillion or more. This process will take years. We have a projected path of shrinkage that the Fed has disclosed. But we also know that the Fed does not intend to shock or derail the economy or markets, so there may be some flexibility in the Fed’s path if a crisis unfolds.

We want to coin a new term. We expect that the shrinkage path will not be a smooth one. Paths to shrinkage rarely are. So we expect to see a “shrinkage tantrum.” That tantrum may remind us (and markets) of the “taper tantrum” that ensued when Fed Chairman Bernanke first mentioned a tapering policy half a decade ago.

The shrinkage tantrum may erupt without market preparation and reflect a global change in sentiment. We think the reaction will coincide with the changes that are forthcoming as the European Central Bank starts to taper up to zero from negative rates. It becomes easy to project a ten-year German government bond trading at a positive interest rate of near 1%, while a ten-year US Treasury note trades at a positive interest rate of 3%. Readers can do the rest of the math to create forward rate curves, a calculation we do every day at Cumberland.

Note that these are estimates of levels. They assume that low inflation remains with us; they assume gradualism by the major central banks; and they assume a baseline of no external shocks like North Korea or an Ebola/Zika outbreak or a recession and/or a constriction of consumer demand and consumer spending and/or sharply contractionary impacts from changes in America’s trade policy (including NAFTA).

Market dynamics alone will pressure interest rates upward. Other factors can exacerbate the direction and accelerate the trend change.

When?

Ay,” wrote Willy Shakespeare in Hamlet’s immortal soliloquy, “there’s the rub” (https://www.poets.org/poetsorg/poem/hamlet-act-iii-scene-i-be-or-not-be).

The numbers we see projected are on a path to be gradual. A 3% US Treasury note may not arrive for another 2–3–4 years. That is the benign scenario. But that projection has no margin for errors. And it has no “expectations” component. And that is where we find “the rub.” How far in advance will markets begin to price in these changes, and how much additional interest-rate premia will bond purchasers require for evolving and uncertain risk? No one knows.

In sum…

There will be a final tax bill. There will be a rising deficit that will eventually pressure interest rates higher. The Fed balance sheet shrinkage exacerbates this transition.

Lastly, a “shrinkage tantrum” probably lies ahead. When, and how serious a tantrum it will be, we cannot yet know.

David R. Kotok
Chairman and Chief Investment Officer
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