Grant's Almost Daily

DO DEFICITS MATTER?

Attention, deficit disorder

That recently-dormant beast called inflation is stirring. This morning, the Consumer Price Index for March showed a 2.4% year-over-year uptick in the headline component, with “core” CPI (that’s without food and energy) also jumping by a sturdy 2.1% year-over-year, the highest in over a year for both readings. That follows yesterday’s figures from the Labor Department reporting that the Producer Price Index jumped by 3.0% year-over-year in March. Strip out food and energy, and the 2.7% year-over-year reading was the hottest since 2011.   

The private sector corroborates the government’s statistical findings. Yesterday, the National Federation of Independent Business released its Small Business Optimism Index for March, finding that a “net 25 percent plan price hikes (up 1 point), the highest reading since 2008.” The Federation cites upward pressure on wages as a catalyst: “With reports of increased compensation running high, there is more pressure to pass these costs on in higher selling prices, although tax cuts and growing operating profits alleviate some of this pressure.”

Those inflationary sightings arrive in tandem with fiscal prognostications that could be described as grim. On Monday, the Congressional Budget Office released its updated Budget and Economic Outlook: 2018-2028.  The CBO now estimates that the annual budget deficit will exceed $1 trillion in 2020, two years earlier than the agency’s June 2017 forecast. Over the next 10 years, the CBO now anticipates a cumulative $12.4 trillion shortfall, that’s up 23% from last June’s estimate and represents 4.9% of expected GDP (compared to 2017’s shortfall of 3.5% of GDP). Federal debt held by the public, which footed to $14.7 trillion as of Dec. 31, 2017, is expected to virtually double to $28.7 trillion in 2028. 

Does the uptick in measured inflation and the fast-deteriorating fiscal picture portend a higher interest rate regime?  Not necessarily, we can infer from the work of Paul Schmelzing, history professor of Harvard University and visiting scholar at the Bank of England. Schmelzing conducted an analysis of the sovereign bond market going back to the 13th century, specifically utilizing the so-called risk free rate cobbled together from the world’s most credit-worthy borrower in each era. As documented in the Nov. 17, 2017 edition of Grant’s, Schmelzing “concludes that fiscal deficits don’t matter, at least not in the setting of bond yields [and] that the average real rate of interest since the year 1311 stands at 4.78%.” 

That proposition, with the near-millennium of statistical weight which underlies it, will be put to the test. Uncle Sam is set to borrow 4.2% of GDP next year according to the CBO, the most since the end of World War II in 1945, after adjusting net issuance for the Fed’s “QT” Treasury sales (the Bernanke era would have seen greater growth in public debt relative to GDP were it not for the Fed’s asset purchases). Meanwhile, the economic backdrop remains benign. The current expansion in output stands at 106 months and counting and, as of April, is tied for second longest since 1854 when such records were first kept. 

The Feb. 9 Grant’s featured an analysis of the United States’ fiscal foibles, and drew a psychological contrast between the bond market’s current complacency in the face of a torrent of new debt and the conditions which prevailed in the prior bear market of 1946-1981. 

“Markets make opinions,” said the departed Richard Russell. In a bear market, new supply is perceived to be bearish, or at least not bullish (another tautology freighted with trading wisdom). Supply is thought to be bearish not, perhaps, because the supply is greater than the demand for bonds at prevailing yields and prices (though that is certainly true), but because the very thought of fixed-income securities has become repellant. That attitude, and its opposite, are years in gestation. “The bond crop never fails” was how disgusted fixed-income investors expressed their free flowing hatred (or love-hatred, as the opportunities for reinvestment of coupon income were forever improving) of an asset class that had disappointed so many for so long. From which it would follow that the Cheney/Reagan deficit doctrine [they don’t matter] is due for cyclical revision.

For the bond market, what’s old is new again.