(Bloomberg View) -- After a short respite in early February, the U.S. bond market's yield curve has begun to flatten again. This bears watching because a shrinking gap between short- and long-term yields is generally associated with the outlook for slower economic growth. But given the tax reform and fiscal stimulus, why is the curve narrowing again in maturities beyond two years? I see two explanations:
- Fiscal deficits will prove unsustainable whether Republicans or Democrats are in power
- If Democrats come to power, they will revoke much of the Republican fiscal and tax moves
Most market participants are skeptical that the recent fiscal stimulus measures, including the tax reform bill, will have enough supply-side impact to come close to offsetting the costs. There are groups of growth-at-any cost Republicans and Democrats in Congress, but they are a minority in each party and rarely vote together, so they do not have true political leverage.
More so than usual, it looks as if the market expects stimulus will be temporary. When deficits and debt start ramping up, the view is that tightening measures will be taken to restrain the red ink, as in the mid-1980s. Some of this is simply the historical political pattern of spending cycles being curtailed relatively quickly when the outlays prove unsustainable. If the Democrats are in power, we will likely see an emphasis on taxing corporations and high income earners. Republicans typically start with trying to restrict entitlements, but end up with similar tax increases when the political difficulty and cost of entitlement restrictions become apparent. As such, given unfavorable global demographics and disinflation risk, there is a cap on longer-maturity yields.
At the same time, it's quite possible that the Republicans lose control of the House in the 2018 midterm elections, and possibly lose so badly that expectations of a Democrat presidential win in 2020 grow. A significant 2018 win by the Democrats in the House and acceptable performance in the Senate could generate expectations that they win the White House, House and Senate in 2020. The Democrats only have 11 Senate seats at risk in 2020 versus 21 for the Republicans. With the "progressive" wing of the Democratic party in ascendancy, the 2020 political configuration could be far more left-leaning than we have seen in decades, if ever.
The Democratic field is wide open in 2020, but it is hard to find an announced or rumored candidate with a strong pro-business tilt. All, or almost all, think that the corporate tax cuts were too deep and that high income earners should pay higher taxes. If the deficits rise as much as feared, it would be both virtuous and politically adept for the Democrats to rescind these measures. If the 2018 midterm elections tell us that the mood of the electorate is shifting to fiscal consolidation as well as toward higher taxes on corporations and the wealthy, bond markets and the S&P 500 Index may begin to discount this risk sooner.
I am making a case this would be bad for markets, but that is not the same as saying it is bad for the country. You can debate whether the Trump administration has followed sound policies, but it is hard to argue that the policies have not been market-friendly. Even after recent gyrations, equities are about 25 percent higher than before the election in November 2016.
Business-friendly is not necessarily pro-growth or efficient. If tax reform doesn’t generate additional investment and hiring, it is essentially a transfer from government to business. It would be good for markets and owners of capital, but would have no beneficial growth effect and a deleterious effect on the fiscal situation. Progressives make the case that too many social priorities have been ignored in favor of business-friendly policies that have not delivered as promised. They would say there is no guarantee that what is good for business is good for the country. These views may be true or not, but if you believe them, you don’t worry about the market consequences of unwinding deregulation or raising taxes.
We don’t have to agree on policy or politics, but in looking at markets we have to look at probabilities and outcome trees. If there is a higher probability that a "progressive" wins in 2020 and a high probability of re-regulation (which a president can do without Congress), or if a tax increase is cobbled together, then the long end of the yield curve will flatten either because of growth worries or an easing of fiscal pressure. A flat curve would not signal an imminent downturn, but would be an indication of skepticism that good times for markets will last.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Steven Englander is the head of research and strategy at Rafiki Capital. He was previously the head of G10 currency strategy at Citigroup and the chief U.S. currency strategist at Barclays.
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