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US budget battles matter

What a Donald Trump or Joe Biden presidency could mean for investors, bonds and budgets.

| 6 min read

Treasury bonds have been disappointing this year. Delays in Federal Reserve (Fed) interest rate cuts have not helped. The Fed continues with a large-scale programme of bonds it owns, which helps depress the market. The battles over the budgets still leave the likelihood of a big financing task ahead, as budgets going forward create a substantial gap between revenue and expenditure. Later this year, the Federal Reserve will cut rates – and may abate its aggressive sales programme. It is waiting for further improvements in the numbers as inflation falls, and some reassurance that there will not be an early resurgence in price pressures.

Meanwhile, the battle of the budget goes on. The budget year started last October. Republicans with a majority in the House of Representatives want to cut discretionary spending on many programmes to narrow the gap with revenues. Democrats wish to maintain and increase the spending. The current deal is to reach agreement on six of the 12 outstanding discretionary spending areas this week and pass legislation for them, and to negotiate an agreement on the remaining six areas by 22 March to legislate for those.

Clock counting down

Four of the areas need a deal by 8 March, as their current spending permissions run out then. This week could see agreement on the budgets for Agriculture, Commerce/Justice/Science, Energy/Water, Interior/Environment, Military construction/Veterans and Transport/Housing. The later ones include defence, which is almost half the total. The early ones passed the House on Wednesday with a large group of Republicans still voting against.

The longer-term battle of the budget matters a lot to markets. All the time Congress and the presidency are split between Republicans and Democrats there will be regular budgetary disputes and the likelihood of short-term agreements and brinkmanship. The two parties have very different views of how big the state should be and what its spending priorities should entail.

They are closest to agreement over maintaining high levels of military spend, though not for Ukraine. They are divided over the very costly health and welfare policy areas. Environment is one of the bigger losers, with a large cut in the budget of the Environmental Protection Agency. They also have a different approach to taxation of large companies and the rich, but both are conscious of the unpopularity of high taxes on middle or low earners. As a result, both parties tend to accept living with large deficits and high debts when they are in partial or complete control of government, whilst being more likely to be critical of excessive debts when in full opposition.

Congressional Budget Office figures show a deficit of $1.7 trillion for 2023 and $1.6 trillion for 2024, with the deficit rising to $2.56 trillion in ten years’ time. This assumes substantial revenue growth of 50% by 2034 with spending growth of 54%. History tells us that there are plenty of spending pressures that both parties are likely to accept. That will mean plenty of new bonds in issue. The state debt of $26 trillion last year rises to $48 trillion by 2034 on these forecasts, reaching 116% of GDP, up from 93% last year. The spending pressures are strongest in the mandatory areas of health and social security, with a 76% and a 70% increase in those.

It is possible that, as the competition between China and the US develops, Beijing will be less keen to hold large quantities of US debt.

The US usually finds it easy to finance its excess spending drawing on very liquid Treasury markets and inviting in savings from around the world. In 2022, holders of bonds experienced big losses as interest rates were hiked, and as the Fed sold some of its bonds off into a weak market. Today, more investors are attracted to the higher yields now on offer and to the prospect of lower interest rates in due course. It is possible that, as the competition between China and the US develops, Beijing will be less keen to hold large quantities of US debt.

The China bloc seeks to create a banking and financial markets alternative to the US-led Western system. Whilst the pressure of new issuance will be considerable, the Fed may well abate or end its programme of bond sales as it seeks to loosen monetary policy, removing one supply of additional bonds. It can then reduce its own holdings as bonds mature which means a slower pace of reduction. At a certain point it will wish to end shrinking its balance sheet to allow commercial banks to hold sufficient reserves at the Fed.

The likely large issue programme should not prevent bonds going up in price a bit as interest rates fall – but it implies there will be limits to how far longer bond yields can fall to take into account the ready supply and the need of the state to offer an attractive rate of return.

In the meantime, as we expected Joe Biden and Donald Trump are close to clinching their nominations as the two Presidential candidates. Polls continue to indicate that both men have a popularity problem with the wider electorate and show that either could win. For the time being, Mr Trump is a bit ahead in most polls.

Bond owners and buyers need to review the contrasting programmes of the two men, with different approaches to spending. They may well conclude that either way US state debt will continue to rise with plenty of new issues. Yields of over 4% for the ten-year Treasury remain attractive on the general assumption of falling inflation and falling interest rates later this year.

Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

US budget battles matter

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