Dear Valued Clients and Friends,
After a long and painful session inside the Rules Committee, the House passed the “big, beautiful bill” the President has wanted this week, with only two Republican dissenters. The bill now goes to the Senate, where I actually think very few changes will take place, given the politics of the whole deal. The sausage-making may have been fascinating for some, stressful for others, and boring as paint-drying for most, but as was foreseeable for us, something got across the House finish line, and is almost surely headed to the President’s desk (or a very similar version is) in the near future.
But why did markets not respond favorably? And why is a supply-sider like me not celebrating the way I wanted to? Even apart from this bill and whatever it means in the short term, how are we to think about the long-term fiscal health of the United States?
Today, I want to look at the good and bad of this bill, the sober reality of the bond market (which defies pedestrian narratives), and the big picture fiscal health of the country. This is a lot to take on for one Dividend Cafe, so buckle up.
I should say that an hour or two before I submitted this Dividend Cafe, the President of the United States tweeted out that he was “recommending” a “50% tariff” on imports from the European Union due to his dissatisfaction with how talks are proceeding. The markets immediately tanked, and as I type, Dow futures are down 600 points (I obviously have no idea where they will go throughout the day). Today’s Dividend Cafe is sticking to the subject at hand regarding the deficit, the tax and spending bill, and bond yields. Whatever the latest in tariff news is will be covered in the “Monday” edition of Dividend Cafe, which will come out on Tuesday (due to the Memorial Day holiday). I assume there is enough time for a half dozen tweets between now and then.
Let’s jump into the Dividend Cafe.
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The Setup
One theory of this week is something like this:
- The House ended up succeeding in passing its budget reconciliation bill
- Financial markets were either surprised they had the political savvy to get it across the finish line, or disappointed in the bill itself
- This all served to stir bond vigilantes as the world’s financial markets (read: the bond market) threw down a gauntlet in protesting runaway government spending and excessive sovereign debt
A couple of problems with this theory of the case are that:
- There is no way financial markets were surprised that they ended up passing a bill
- The bill itself and its actual deficit impact were no surprise whatsoever
- And bond markets did no such thing!
As I type, the 10-year bond yield is sitting at a whopping 4.48%. My friends, if you believe that is vigilantism, you never met Bernard Goetz.
Here is the 10-year bond yield over the last 65 years, which I would like to point out is longer than the amount of time I have been alive:
Okay, I suppose this covers too much time. I mean, who wants history to get in the way of a little clickbait melodrama BS? But let’s just look at a little more recent history:
Well, what do you know? For the last two years, the 10-year has basically been between 4% and 5%, and it is right now smack dab in the middle of that two-year range. There have been all sorts of points where bond yields moved higher than they are now, just in the last two years. Yes, there were other little rally moments where they dipped lower, too. But all things being equal, this has been a reasonably non-volatile period for bond yields, with a range that has mostly been in a pretty rational bandwidth of uncertainty around the single thing that is, itself, most uncertain: Nominal GDP growth. So this brings us to a pretty important reminder …
The Long Bond Measures Economic Growth Expectations
Nominal GDP growth = Inflation + Real Growth
Put differently, nominal GDP growth measures total economic growth, without adjusting for inflation. Real GDP growth measures nominal GDP growth minus inflation. And the 10-year bond yield is, more or less, meant to capture in real pricing what financial actors believe about total economic growth (nominally) over the period of time between the money being lent and the money being paid back.
The composition of nominal growth between inflation and real growth matters, for a lot of reasons, but the bond market is there to measure the combined impact. If you believed in a pretty benign inflation level, say something 1-2%, and you believed REAL growth would be the U.S. post-war, pre-GFC trendline of 3.1%, then you might want 4-5% to part with your money for ten years. If the economy were to grow that much for ten years, one would think someone could find an investment opportunity that was linear to economic growth (i.e., investing in the same things that were making the economy grow that much) – so therefore receiving a yield in line with that opportunity cost is pretty rational.
Now, from 2009-2020, inflation was only about 1-2%, and real economic growth was about 1-2% – and the 10-year bond yield floated between 2 and 3% …
I will say it as many times as I have to in the years ahead, but the composition of growth and inflation expectations within nominal GDP expectations will vary, but fundamentally, the 10-year bond yield will capture 10-year expectations around the aggregate nominal GDP expectation.
Say More
Did you notice what I did in the above paragraph? I used the greatest example possible: 1-2% inflation and 3%+ real economic growth to paint a picture of what? A 10-year bond yield that would be … about 4.5% or 5% ?????
And I used a real-life example to paint a picture of a really low bond yield because economic growth was very weak (i.e., 2009-2020) …
What would be a really bad scenario where bond yields were much higher? 4% inflation and only 1-2% real growth, with a term premium around uncertainty, pushing yields up to 6%? Well, that would be bad. Keep me posted.
And what would be a really bad scenario where the 10-year bond yield was much lower? 1-2% inflation sounds good, but 1% real growth is bad, and that composition would point to something closer to 3%.
I can easily do the good side. There are combinations of inflation and real growth that could bring bond yields lower that would be good (say, 1% and 3%), and other combinations that would push yields higher (say, 2% and 3.3%), and both would be good.
But the very ironic thing about people suggesting 4.5% is somehow “bond vigilantism” is that 4.5% is probably the best possible bond yield, if the goal for nominal growth is 4.5 – 5%, with some inflation between 1.5 and 2% and real growth around 3%. Now, we don’t exactly have that yet, but I would be very careful what one wishes for.
A 3% long bond yield (or anything sub 4%) is nothing more than a vote on Japanification, period.
Yes, something well north of 5% (especially if real growth is only between 2 and 2.5%) is likely reflecting higher inflation expectations and some sort of term premium that speaks to bond uncertainty. But again, keep me posted.
Are You Saying Everything is Okay?
Hell. No.
The broad picture for U.S. debt is that total debt is getting very close to $37 trillion, and public debt (money we owe to others besides to ourselves) is roughly $29 trillion. The last fiscal year’s annual budget deficit was $1.8 trillion (how much we are adding, year-by-year) to the total credit card balance. The budget deficit as a percentage of the economy is a staggering 6.1% (it ran between 0% and 3% from 2001 to 2020, except during the year of the financial crisis). The total federal public debt to GDP ratio sits at about 120%, 3x what we had from 1960 to 1990, and 2x what we had from 1990 to 2010. It is just completely, totally unsustainable and unacceptable.
There I Go Again
But notice again something I did there. I am showing a growth of public debt over the 30, 50, and 70 years, and a growth of the debt relative to the size of the economy (over decades), not that is merely forecast to happen in the future, but that has already happened. And we did not fall into the ocean or spontaneously combust, yet (I promise I will get an email saying that we actually have, and none of us are really here, and how dumb am I to not know that we all died years ago, but you get my point). The fundamental concern I have is with the continued growth of our debt at a higher pace than the growth of the economy itself. Years and years of growth of spending set the stage for a reversal, but it was not a drain on growth until growth of debt outpaced growth of real goods and services – at that point, it re-allocates resources unproductively, and puts downward pressure on economic growth. And that is unacceptable.
Which Brings Me to This Tax and Spending Bill
My hope had been for a tax bill that would spur economic growth, wherein the principles of Laffer’s curve (a lower effective and marginal rate that generates more revenue) would be allowed to work. I honestly do not understand why this is debated. The reduction of corporate rates in 2018 and thereafter has led to more corporate tax revenue, which is empirically incontestable. That Clinton tax reductions in capital gain rates in the late 1990s led to far more capital gain tax revenue is demonstrably true. That Reagan’s marginal rate cuts led to far, far more economic growth (and tax revenue to the treasury) is the easiest economic data point of my lifetime. And to round out the bipartisanship of my observation, John Kennedy’s tax cuts (implemented after his assassination) also did the exact same thing – lower rates, and higher revenue.
Now, I do not believe all tax cuts are created equal. I do not believe “no tax on tips” is a supply-side pro-growth policy the way that broadly reducing rates is (i.e., all capital gain, or all marginal income rates, or all corporate income rates, etc.). The issue is incentives and productivity, and broad-based reductions do that more than politically targeted cuts, let alone ones that go away in three measly years.
The challenge of the current bill was not to see an increase in people’s marginal rates (primarily middle-class wage-earners) by extending the sunsetting Trump tax cuts from 2017, and at the same time neutralize the deficit impact with serious spending reform. The bill extends the Trump tax cuts of 2017, which raised taxes on people like me, and I am all for those tax cuts being extended (the honest way to say this is – I am all for a massive increase in their tax burden from what they have been paying to what they would then be paying without extension).
But did the spending reform come? Of course not. The bill is projected to increase the debt by $3 trillion over the next decade. Now, I will grant that some of my friends who object to this criticism argue that there is a very good chance that the estimate is overdone. The CBO notoriously (and understandably) under-scores dynamic economic growth from tax reform, and groups like the CRFB notoriously overstate the deficit impact. Regardless, the bill unequivocally adds trillions to the national debt over the next decade, and it was entirely unnecessary.
Political Reality
I am not Pollyannish about what needs to happen. It is difficult to cut spending in a democracy because you are taking something from somebody. I get that. People can say, “well you anti-tax people have made it hard to cut taxes, too” but the difference there is: (a) You will forgive me that I believe the tax rates and tax burdens are already excessive, and (b) You cannot raise taxes without a diminishing return – you cut into the revenue base and GDP denominator with additional tax burdens; you can cut spending without cutting into GDP (in fact, you can enhance it by re-allocating resources more productively).
But all that to say, there are “pay-fors” in this bill I like a lot, but there could have been more. There is some minor tweaking in Medicaid abuses that I like a lot but there absolutely, for sure, no question, could have been more.
There were SALT concessions given that are almost incoherent in their efficacy, and yet, they were a ransom that had to be paid to get the votes. Other things I would have done or not done would have had a political cost, too. I do not write Dividend Cafe from inside the legislative arena; I write it as a spectator trying to objectively call balls and strikes. But the political challenge of a bill that does not add to the debt does not change that this is a bill which will add to the debt, and it is the one thing I want a politician to come do – address this unsustainable debt fiasco.
The Easter Eggs
What has been hidden in the bill that is most pro-growth is bonus depreciation (full expensing), domestic R&D deductibility, greater deduction of interest expense on corporate borrowings, and additional opportunity zones through 2033. These are investor perks that are pro-growth, and candidly, unappreciated so far. They should last through the Senate version of the bill, and in the end, be a net positive for many small and large businesses.
Is There a Senator Who Will Block This Tax Bill?
A very legitimate question now that the House has gotten this bill to this point is whether or not there are any Senators who will obstruct its passage. Ironically, I would argue that the political capital the President had to use (i.e., threats, name-calling, arm-twisting, etc.) to get this bill over the finish line with the House makes it less likely that there will be successful Senate challenges to what the House has passed. It would seem that there has to be a few cosmetic tweaks here and there, but the things I would have expected some Senators to hold the ground on a few months ago I just don’t believe are still on the table.
Do more than three Republican Senators find the increase of the SALT cap outrageous? Do more than three Republican Senators believe the adjustments for Medicaid are not nearly substantial enough? Do more than three Republican Senators believe the bill does not do enough to cut spending over the next ten years? Do more than three Senators feel there are plenty of things that ought to be changed?
The answer to all of the above questions is yes. But will there be four “no” votes from the Republican side (and one could argue it would take five because I would not be remotely surprised if John Fetterman of the great state of Pennsylvania crosses the aisle to vote yes)? Not a chance. I will be surprised if it gets two no votes from Republicans, and three is the max. Four or five? No way. Expect some speeches, jockeying, and maybe a few last-minute dramatic moments. Then expect it to go through with minimal change. Just calling it as I see it.
Conclusion
What we have, my friends, is a tax bill that in one way or another is going to pass. And that is a good thing for the economy in avoiding a risk (but it was a risk that was never going to happen). It comes with silly stuff (campaign tax stuff) which does not cost a lot, but I am still allowed to call it silly (because it is). It also comes with a spending package that is disappointing to those who want to address the fiscal situation sooner rather than later.
But just understand, dear reader, that is all we are talking about – sooner or later. This WILL be dealt with. And I wish it would be sooner, because whatever we deal with later gets a lot harder.
But I am just a money manager calling balls and strikes, and no one cares what I have to say. The bond market doesn’t care much right now, either. Maybe one day it will, and that will make politicians care. Maybe one day something else will trigger the needed amount of care. But this is tricky stuff because there are no good solutions. Understanding trade-offs is the heart of the matter. In fact, understanding trade-offs is the very essence of economics. That simple, back-to-basics might be exactly what the doctor ordered.
Quote of the Week
“It turns out the better you are with numbers, the better you are at spinning those numbers to conform to and support your beliefs.” –
~ Annie Duke
* * *
The party not in power cares about fiscal discipline. The party in power does not. Rinse and repeat. And if you believe this only applies to the party that you are not a member of, I encourage you to look at it through the lens of immediate history. It is what it is, until it isn’t. Transformative moments, people, and events happen in history, and there will need to be such here, too. But for now, “the people wanted a King.”
With that said, let’s go Knicks … And Happy Memorial Day weekend to all. I love this country with my whole heart, I really do. And when I criticize the things that have led to this fiscal position, it comes from wanting better, and nothing else. To that end, we work.
With regards,
David L. Bahnsen
Chief Investment Officer, Managing Partner
The Bahnsen Group
thebahnsengroup.com
This week’s Dividend Cafe features research from S&P, Baird, Barclays, Goldman Sachs, and the IRN research platform of FactSet
