The recent deal by Congress to avoid a government shutdown may have positive effects on equity markets, but it also raises concerns about fiscal discipline and its impact on bond markets. Over the past year, the fiscal deficit in the US has dramatically increased, supporting economic growth but also raising questions about the government’s ability to spend without long-term fiscal discipline and funding. As a result, the US Treasury is expected to issue around $2 trillion in new supply, leading to poor performance in the longer end of the Treasury market and increased ten-year yields.
Although it is expected that the Federal Reserve will provide the necessary funds for the government to meet its obligations, doubts are emerging about the sustainability of these programs. Factors such as the end of quantitative easing by the Fed, a decrease in foreign demand for the US dollar, and banks’ inability to step up as buyers create uncertainty about who will purchase this significant new supply. This lack of funding poses a risk that markets have not recently faced when budget deficits become unruly.
Historically, lack of funding has resulted in significant belt tightening exercises, as seen in 1994 when ten-year Treasury yields surged to 8%. The bond markets exerted pressure on Congress, resulting in bipartisan measures to address the deficit. However, it remains uncertain whether similar proactive fiscal discipline will be implemented this time. Investors are skeptical and fear that if markets continue to push for action, it will negatively impact already high equity valuations. On the other hand, if Congress takes the lead and implements spending cuts or tax increases, it could hinder economic growth. Ultimately, higher rates or smaller budget deficits both present short-term challenges for stocks.
