US Fiscal Policy Is Still on a Slippery Slope
- By Vasileios Gkionakis
- 5 min read
Summary
- US fiscal policy is extremely loose and the most misaligned with underlying economic dynamics since 1980.
- Despite Wednesday’s announcement, the US budget deficit appears to be some 5ppts (of GDP) wider relative to employment trends.
- This risks even higher bond risk premia, keeping yields higher than cyclical growth can justify, which could prevent the US government from effectively managing the next recession.
Market Implications
- Longer-dated yields will likely decline in 2024; whether the risk premium will allow nominal yields to fall enough to cushion the slowdown is still up for debate.
- Equity indices and volatility continue to pay little attention to growth, geopolitical and debt risks; I fear 2024 will be a very bad year for global equities.
- I am still constructive on the dollar but acknowledge that failure to control the budget balance could result in recession gains being offset by investors requiring a higher risk premium for USD-denominated assets.
Introduction
I am a big believer in the role of central governments and fiscal policies. However, I equally (and strongly) believe fiscal policy must be countercyclical, i.e., broadly anchored (negatively) around cyclical growth. This means two things:
- Spending must increase in recessionary periods to cushion economic hardship and ensure no or minimal rips in the social fabric.
- It must be prudently managed in periods of expansion to maintain sovereign credibility and, importantly, build ammunition for the next cyclical downturn.
As a side note, I do not think that, in principle, fiscal and monetary policies need to be in perfect sync: their separation via central bank independence has made it clear that inflation falls entirely within the remit of central banks.
Having straightened that out, I will argue that US fiscal policy is moving along a very slippery slope: since 1980, US fiscal policy has not been looser when considering the underlying economic dynamics.
Putting aside inflation concerns – which monetary policy could deal with – the main issue relates to risk premia. These still threaten to push longer-dated yields higher in the near term and, eventually, prevent the US from effectively managing its fiscal response to the next recession – which I believe is very likely in 2024.
Markets Celebrate the Quarterly US Treasury Refunding Announcement…
Markets rejoiced on Wednesday when the US Treasury announced plans to increase government bond sales in Q4 2023 by less than investors expected. This triggered a 20bp decline in US 10Y yields, its largest daily drop since the recent ‘bond tantrum’ began in the summer. Dovish FOMC hints alongside a disappointing ISM manufacturing report compounded the move.
This is a welcome development, especially given the share of longer-dated marketable issuance vis-à-vis T-bills has fallen over the last three quarters. Yet a more fundamental issue remains: US fiscal policy in the last year or so has become highly pro-cyclical:
- Trends in net quarterly marketable debt issuance show a steady increase since September 2022, even considering the US Treasury’s projections for Q4 2023 and Q1 2024.
- The US budget balance is at historic deficit levels, sharply contrasting the underlying employment dynamics.
…But US Fiscal Policy Is Still on a Slippery Slope
Looking at the raw level of an economy’s budget balance can be misleading because it does not condition the ‘nominal’ balance (as a percentage of GDP) on the economic cycle. Enter ‘cyclically adjusted’ balance, which accounts for the economy’s output gap, relying naturally on estimates of potential growth.
I will take a more practical approach and estimate the relationship between the US budget balance and US unemployment rate, with the latter (more) observable when compared to output gap estimates. Economic intuition suggests low unemployment should be associated with budget surpluses/lower budget deficits and vice versa.
The upshot is that current US fiscal policy is looser than at any time during the last 35 years or so. Namely:
- My estimates confirm the negative relationship between the unemployment rate and budget balance: on average, every 1ppt increase in the unemployment rate has been associated with around 0.9% of GDP deterioration in the budget balance.
- Crucially, current estimates suggest the US budget deficit is nearly 5ppt (of GDP) wider than it ought to be. Putting aside 2020 – when the extraordinary nature of pandemic uncertainty justified a sizeable increase in fiscal spending – 2023 marks a year of unprecedented loosening in (employment-adjusted) fiscal policy.
Why Is This Very Risky?
Untimely loosening of fiscal policy can harm markets and the economy.
To the extent markets perceive such a policy as irresponsible, risk premia on government securities will rise, leading to an increase in bond yields above what cyclical growth can reasonably justify.
With interest rates at multi-year highs, this risks depressing economic activity and weighing on household consumption, especially as excess savings are declining.
Ultimately, any government will find itself needing to restore its sovereign credibility rapidly by reducing spending to compress risk premia, right when public welfare programs must expand.
In the end, a deep recession becomes the most likely scenario.
Market Implications
As I have argued before, I think 2024 will see yields declining and yield curves steepening. The million-dollar question, however, is whether the decline in longer-dated yields will be sufficient to increase the likelihood of a garden-variety recession; if risk premia prevent yields from falling enough, a deeper recession becomes more probable.
I still think that 2024 will be a bad year for risk assets. At 16%, the VIX index comes nowhere close to pricing in growth, geopolitical and debt risks. It is also out of sync with the performance of the equally weighted SPX vis-à-vis the headline index.
On the dollar, I remain constructive but acknowledge the balance between the global recession and US fiscal policy will determine its fate. A world downturn is fundamentally positive for the USD. However, if US fiscal policy fails to brake in the next few months, US risk premia will rise sharply, depriving the dollar of gains.
