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I. The Fallacy of Linear Thinking

While President Biden grapples with alligators in the Middle East, disorder has erupted domestically. The turmoil in the House leadership has revolved around the federal deficit, which is perceived by fiscal conservatives as an existential concern.

Our approach: As usual, we aim to inject rational thinking into seemingly irrational situations. While there is little doubt that deficit spending levels are sobering, gaining perspective might prove helpful.

II. Pending Elections

We anticipate the deficit will become a major theme in Washington over the next few weeks and during next year's presidential campaigns. Whether desired or not, the current administration is likely to be compelled to moderate spending. Prevailing interest rates may be the decisive factor in the upcoming battle. On one hand, interest costs rose by 87% over the past year¹. On the other hand, many economists anticipate substantial cuts by the Fed².

III. Powell Pause

While Mr. Powell might claim commitment to elevated rates, we anticipate some moderation arriving in time to influence the pending presidential elections. Despite moderated inflation levels, 10-year treasuries are trading at levels exceeding recent inflation, reflecting concerns about the federal government's willingness or ability to rein in spending.

IV. Sea Change

While the phrase "this time it’s different" has become axiomatic, the key question is whether this time is sufficiently different. From our perspective, the major market shift is the power of central banks. Through “Quantitative Easing,” central banks wield essentially unlimited purchasing power, shaping markets (at least in the short and medium term) to their liking.

V. Myopia Mistakes

We are often unaware of the air in which we walk. Similarly, market participants accept much of the current thinking without understanding how we arrived at the present position and whether it is likely to persist. For instance, how many professional managers expected Fed Funds rates to increase by over 500 basis points in less than 18 months? The short answer is very few. In retrospect, this is understandable, given the record spending and massive quantitative easing. However, both are now history, begging the question of whether current conditions will persist.

VI. Synthesis/A Rare Prediction

Typically, we refrain from making predictions in these columns. However, given the unsustainability of current trends, we assume they simply will not be sustained. A corollary is when a problem is too big to be solved; it simply will not be solved. Our view is that we will not slip into a situation where most tax collections will be spent on paying interest. A more likely scenario is that government budgets will be cut, and the Fed will reinitiate quantitative easing to suppress interest rates. Nonetheless, we remain vigilant.

Sources

[1] Bloomberg - U.S. Kicks Off Fiscal Year With an 87% Surge in Interest Costs

[2] Bloomberg - Goldman Sachs, Morgan Stanley Diverge on Fed Rate Cut Forecasts