US Budget Deficit Will Lead To A 30% Market Crash

US Budget Deficit Will Lead To A 30% Market Crash

According to CNBC, there’s a ‘$2 trillion’ mystery in the Trump administration’s budget. This ‘mystery’ is a windfall $2 trillion in additional tax revenue that policymakers believe will materialize thanks to the budget’s proposed tax cuts. By using a process called “dynamic scoring” officials estimate Trump’s proposed cuts will lead to sustained economic growth of 3% per annum, generating as much as $2 trillion in extra tax revenue over the next decade.

Whether or not this $2 trillion fiscal boost will ever materialize is up for debate but according to analysts at Bank of America, no matter what the outcome of the tax reform process, the US Treasury is underfinanced by anywhere between $2 trillion to $4.5 trillion over the next five years.

This massive deficit will require a substantial increase in auctions sizes of US Treasuries and/or new products according to the bank’s analysts. What’s more, it is likely the US government will have to pay significantly higher interest rates in order to encourage investors to pick up the additional supply.

US budget deficit will lead to a 30% market crash

In a research note published earlier this week Bank of America’s rates analyst Shyam S.Rajan speculates that based on current demand levels, there is likely to be a $1 trillion shortfall in demand for US Treasuries over the next five years as supply increases. To attract investors to pick up this additional supply, the bank’s analysis suggests either rates need to be 120 basis points higher or stocks need to fall by 30% for supply/demand estimates to match.

The scale of new supply hitting the market over the next few years will certainly have some impact rates according to Bank of America. Specifically, given the substantial issuance undertaken until 2015, the profile of maturing debt increases every year until 2020 driving gross refinancing needs higher. Also, Federal Reserve run-offs will increase public issuance needs by about $200 billion to $250 billion a year. On top of these two factors, tax reform/tax cuts could add $200 billion to $400 billion in additional issuance needs, and in the bear case, if a recession were to start next year, federal receipts could fall by $250 billion to $400 billion per annum. Add all of the above together, and the federal government is underfunded by around $1 trillion a year, requiring an additional $3 trillion to $4.5 trillion over the next five years.

Over the past decade, the US Treasury has been able to rely on foreign buyers, domestic banks, foreign private investors and the Federal Reserve to hoover up Treasury issuance every year. However, Bank of America argues that these buyers and now basically exhausted and as a result, the Treasury will struggle to find buyers for its new bonds. Mr. Rajan notes that Chinese demand for Treasuries has gone from accounting for 40% of net supply from 2004 to 2014 to being negative over the past two years. Meanwhile, domestic banks, which have purchased around $300 billion of Treasuries in the previous five years have been net sellers since the election, dumping $26 billion of US Treasury securities year-to-date. And lastly, foreign investors, who have scooped up Treasuries as quantitative easing has depressed rates in Europe and Japan, might now be heading back home as QE operations start to come to an end.

All of the above could mean that the Treasury faces a huge shortfall in demand over the next five years:

“Using a baseline of our Fed portfolio runoff schedule and assuming no stimulus, the Treasury faces a shortfall of ~$2 trillion over the next five years (primarily starting in 2019). We assume that the Treasury will finance nearly 50% of this in sectors with heavy demand – bills through 5s. On top of this we will also assume that the current auction sizes have more than sufficient demand. This leaves the Treasury to net increase 5y-30y auction sizes by approximately $4bn each. We only assume that this additional increase in auction sizes will need a new sustained buyer, leaving a demand shortfall of ~$1 trillion over five years.”

The report goes on to note that the only two substantial buyers left after excluding foreign sovereign nations, foreign investors and domestic banks are pension funds and mutual funds. Pension funds are likely to be the most substantial customers in any scenario thanks to their constant need for high rated predictable income bearing securities. But unless there is a substantial increase in the yield on Treasuries, pension funds might not be inspired to take the plunge:

“Currently, asset allocations for these pensions stand at ~ 35% equities, 45% fixed income (with 20% in other assets)… to assume that as pensions reach a 100% funded ratio, they will likely move out of equities to a fully fixed income portfolio…So in the most simplistic case, a 120bp increase in rates, will lead to a $600bn outflow from equities into bonds (35% of $1.7 trillion) from the top 100 plans. Scaling this up to the entire universe of DB plans ($2.9 trillion) would suggest that a 120bp increase in rates, will lead to a total of ~$1 trillion in demand from this community for fixed income assets.”

For mutual funds to meet the same level of demand, it’s estimated a 30% equity market correction would drive a $1 trillion rotation from equity mutual funds to fixed income mutual funds thus meeting the additional demand requirements.

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Source: valuewalk