The following statement made by President Trump in mid-October of 2017 sent many economic professionals into a tizzy.
“In the last 10 years they borrowed more than it did in the whole history of our country. So they borrowed more than $10 trillion, right? And yet we picked up more than $5.2 trillion just in the stock market, possibly picked up the whole thing, in terms of the first nine months in terms of values. So you could say in one sense we’re really increasing values and maybe in a sense we’re reducing debt.”
This bizarre statement, not unusual for Trump, sent many economic professionals into a tizzy. It is preposterous, they contended, that movements higher in the stock market have anything to do with the ability of the U.S. government to amortize the National Debt, which has now surpassed $20T and climbing quickly since September 2017. From an economic perspective, it is GDP that drives a country’s ability to service its IOUs, not the stock market casino. But in the Trump world, fortified by a bevy of Wall Street advisors, the current view is that as long as stocks are strong, more debt is not bad for the USA. Why the sudden change of tune?
The reason involves how the U.S. government, led by Trump and minions of structured finance geeks from Goldman Sachs and other investment banks are going to get the financial markets to free up enough capital to finance the Trump Tax Reform bill. I call it the Trump Put.
Currently, President Trump is reveling in the passage of a Tax Reform Bill which he is convinced will drive the economy into hyper-drive. However, there is one big problem with the Tax Reform Bill, it needs to be financed.
This time around, compared to the past 8 years, Wall Street is going to do the “Swap” to fund the government, not the Federal Reserve. Under Obama, the “Beltway Swap” paved the way for increased government spending in 2010, and sustained that spending through time while keeping interest rates at all-time lows for 8 years running. The Federal Reserve is not going to be the direct source of funds this time around. In fact, the public record now shows the Fed planning to dump U.S. Treasuries and MBS securities from its balance sheet over the next 3-4 years. In other words, financial leverage from another part of the financial system is going to have to step up to carry the water.
Large Increase in National Debt Lurking
The Federal Reserve planned balance sheet run-off plus the Tax Reform Bill mean there is a “huge” funding requirement which is lurking for the financial markets to digest over the next several years. Just how big is it going to be? The U.S. Treasury has laid out just the tip of the iceberg in terms of the near-term borrowing that will be needed to finance the government as we head into 2018 as the Tax Reform Bill passed in December.
The Treasury will issue $275 billion in net marketable debt from October through December 2017, assuming a cash balance of $205 billion at the end of the period, according to a statement released Monday in Washington. From January to March 2018, the Treasury predicts issuance of $512 billion in net-marketable debt, with a $300 billion cash balance by end-March.
And currently the Treasury is sitting in limbo as of mid-January 2018 in its ability to finance the “massive” tax cuts because Congress punted on raising the National Debt ceiling after passing Tax Reform just before Christmas in 2017. Once the Treasury is unleashed again, as it was in early September 2017, expect the pressure on rates to continue to rise to a boiling point because there is plenty of pent up borrowing need being felt at the Treasury.
Here is the U.S. Government borrowing need as projected by the CBO, US Treasury and Goldman Sachs over the next 4 years:
At $1.2T the federal government is slated to need 2.5 times the amount of new Treasuries in 2018, including the scheduled run-off of the Fed balance sheet of $179B, than in 2017. And the large financial hole in the budget is expected to expand over the remaining years of Trump’s first term as President.
In 2017, the very low level of new government borrowing led to a declining rate structure on the long end of the curve up to early September. And, as the Fed initiated rate increases on the short-end of the curve, the yield curve spread contracted to 90 basis points.
Currently the 10 Year Treasury is on the precipice of breaking through a key resistance point of 2.60%. Once the Treasury plows into the market with its “huge” borrowing machine after the upcoming budget showdown, this resistance point is likely to become a floor left in the dust bin of history for some time to come.
What does the National Debt have to do with the Stock Market?
Many economists have been dumbfounded by the connection being made by Donald Trump to stocks and the National Debt. Under economic theory, a country’s GDP is what is available to amortize the national debt. In the “Art of the Deal”, higher GDP is an aspiration. The goal is to get the deal done, and let those who get on board take the spoils and create the outcome, and those who don’t suffer the consequences. The obvious supporters are the corporations who are going to lower their future tax liability once the deal is done. But there is a second big winner in this deal. It is Wall Street in general, which will regain considerable power that it lost post the 2008 financial crisis.
Currently the stock market is in maximum greed mode as we enter the 2018 New Year, with broad market gains in excess of 40% being booked by the DJIA since Trump was elected in November 2016. Every morning when I check the futures, they are signaling another up day. Times are truly grand – and my portfolio has benefited. Stocks are bursting higher on the broad index level on the expectations of higher free cash flow in many companies now that the Tax Reform Bill has passed. And in the meantime, interest rates remain stubbornly anchored, because there is so much excess liquidity in the financial system because of the prior 8 years of Federal Reserve excesses, and the Treasury is trapped in a debt ceiling battle.
In an effort to keep the stock market calm ahead of the borrowing storm, the long-end of the Treasury curve is now being held lower than normal as the Treasury is issuing most of its new debt in the 1-5 year window (at the behest of China). As a result, the ten year Treasury rate looks tame, but is still rising. Once the 10 year breaks through 2.6%, expect the business media mantra to turn to “higher rates are good for stocks because it shows an expanding economy.”
GDP growth is not the real Wall Street goal at this point in time, but it has suddenly become the talking point. Wall Street’s goal is take back power lost when the market tanked in 2008 and the Fed and Washington took over the banking system. Based on many estimates, GDP growth won’t change much once the deal is done. In fact, I estimate in the short-term there may be damage to the economy, particularly in high priced real estate centers like New York, DC and the tech center of the universe, Silicon Valley.
As stocks go higher, institutional investors like insurance companies, by rule re-balance their portfolios and buy more risk free government bonds. A perpetual motion “Wall Street – Washington Swap” has been set into action. The winners and losers in this Trump deal will be those who understand the swap that is taking place, and know when they should get off the stock merry-go-round.
Biggest Risk in the Tax Reform Bill – No Guarantee Corporate Tax Cuts will Produce U.S. Growth
Based on the concerns being voiced by a respected Republican Senator, Bob Corker who did not vote yes on the Tax Reform Bill, odds are high that the U.S. economic growth path will not be as rosy as Republicans and President Trump are posturing today.
Personally I believe the path being chosen is better than the alternative that was jettisoned, only because it sets the economy back on a path to being market based rather than Washington based. But, in my assessment, the change does not justify a 42% increase in the broad market. What I dislike about the Tax Reform Bill is that the mucky-mucks in congress, Mitch McConnell being the ring-leader, have used the opportunity to provide a big Wall Street pay-off with no strings attached to generate GDP growth for Main Street.
The original Trump economic plan was based on driving jobs and growth into the U.S. by leveling the playing field on the import and export of goods into the U.S. through a Border Adjustment tax. My research, laid out in the book Theory of Financial Relativity, provides powerful evidence that it is this imbalance that is the source of deflation and poor U.S. economic growth since the end of the 1990s in the United States. There is a strong contingent in Congress, both Republican and Democrat, that have a donor class that does not want to see this trend reversed because they are fully invested in the job stripping of America. As a result, the path that is being chosen does nothing more than solidify the status quo, and rewards it with a lower U.S. tax rate.
When does the Euphoric Stock Market return to Economic Reality?
The answer is simple, once the risk-reward tipping point between stocks and Treasury bonds is reached. The smart money behind the Wall Street greed machine is always hedged with a bucket of risk-free collateral. Currently that collateral has a very low interest rate because there is too much excess cash in the system. The Federal Reserve plan to drain the system of excess reserves by design will systematically raise interest rates; it is only a matter of time.
Once Treasury rates reach the point where “risk-free” rates exceed equity return growth expectations on a risk-reward basis, the stock market, built on high expectations today, will hit a resistance point. Now that the Tax Bill passed in December 2017, the testing of whether the over-extended stock market is ripe for a drop will begin in 2018, most likely heading into the 2018 fall election season. However, market vigilance is advisable from now forward until this change from the “Fed Put” to the “Trump Put” is fully and correctly priced into the stock market. Currently the market pricing mechanism seems conspicuously one-sided.
The Flaw in the Trump “Put”
Given the current disconnect between economic reality and stock valuation, created by a very over extended “Fed Put” and augmented by a global “Central Bank Put” around the world, my expectation is that stocks are on a path to collapse quickly as the Tax Reform Bill is financed. And the scapegoat when the market corrects will be the Trump Presidency. Why? For starters, Trump inappropriately in my opinion, has front-run the stock market with the false idea that somehow his policy change justifies such a “massive” move in stock valuations. Stocks that were inflated at the out-set.
Now, Trump is pushing a narrative that 3% GDP growth will somehow justify the stock market run-up since he was elected. There is a glaring flaw in the Trump economic plan logic. The one part of the Tax Reform deal that Trump is missing is the guarantee that money being transferred to corporate coffers in the bill will return as wage, job and economic growth in America. Corporate stock buy-backs can only prop up the stock market and flush excess cash into Treasury to finance the U.S. National Debt for so long. Eventually the music stops, and likely in abrupt fashion as the oil barons and bond vigilantes from the Middle and Far East return with a vengeance to get their share of the Washington fiscal policy hand-outs.
Expect the "Trump Put” to be tested by the market, and very soon.
Daniel Moore is the author of the book Theory of Financial Relativity. All opinions and analyses shared in this article are expressly his own, and intended for information purposes only and not advice to buy or sell.