Big-spending budget pact rattles markets, threatens 'next fiscal crisis'

Key Points
  • Congress agreed on a spending plan late that increases discretionary spending by $300 billion.
  • The new budget helped end a very brief government shutdown but raises questions about fiscal stability.
  • Debt will increase by $420 billion over the next 10 years, pushing the budget deficit above $2 trillion, according to the Committee for a Responsible Budget.
  • Stocks struggled through another whipsaw day of trading following the agreement.
Congress reaches budget deal to end short government shutdown
Congress reaches budget deal to end short government shutdown

Investors weren't relishing the idea of a government shutdown, but don't appear terribly excited with what they got in its place.

A budget that increases discretionary spending by nearly $300 billion in the coming years helped fuel worries that profligate federal spending would set of a chain reaction that triggers a recession, and ends the bull market in stocks.

The market whipped back and forth Friday, hours after the bipartisan agreement came about that ended a blink-and-you-missed-it government shutdown. While the threat of a prolonged impasse went away, the accord's long-term ramifications will not.

The Committee for a Responsible Federal Budget broke down what the numbers will mean to the nation's fiscal picture: An addition of $420 billion to the national debt over the next 10 years, due to interest payments, and a deficit of more $2 trillion of annual deficits by 2027 if the tax cuts passed at the end of 2017 are made permanent.

Those projections don't even touch infrastructure spending. If President Donald Trump gets his way, before year's end the nation will be engaged in a $1.5 trillion program to upgrade public transportation, roads, bridges and other public works projects.

There is a risk that Congress' new-found largesse is sowing the seeds of the next fiscal crisis when a recession inevitably hits.
Andrew Hunger and Michael Pearce
Capital Economics

What that means in the near-term is probably growth, at least in terms of GDP. The increased spending will grease the economy's wheels, and there likely will be a parade of upgrades to the 2018 growth projections.

But there's another side to all the free spending: The real possibility of an uptick in inflation — which this market currently fears more than anything. Already, the Treasury is forecasting nearly $1 trillion in borrowing needs this year, a sum that it projected to rise in subsequent years.

Combining the tax cuts and rise in discretionary spending likely will push the deficit, currently pegged at about 3.4 percent of GDP, to more than 5 percent by the end of 2018. That would put it at its highest-ever peacetime level outside of recessionary periods, according to Capital Economics.

"Fiscal policy could become a drag on the economy by 2020 if Congress failed to agree on a new deal to raise spending levels again, and the previous caps were re-imposed," economists Andrew Hunter and Michael Pearce at Capital economics wrote in a report for clients.

"Furthermore, there is a risk that Congress' new-found largesse is sowing the seeds of the next fiscal crisis when a recession inevitably hits," the analysts added.

Return of the 'bond vigilantes'?

In the meantime, the economy is looking at fairly blue skies.

Goldman Sachs on Friday nudged its Q4 GDP forecast up to 2.6 percent, and the Atlanta Fed, though off its recent high of a 5.4 percent projection, still sees first-quarter growth coming in at 4 percent.

Longer-term, though, the picture gets less clear, and that's one of the things that has the market worried.

Investors have received several inflationary jolts over the past week and a half. These include Treasury Secretary Steven Mnuchin's seeming endorsement of a weak dollar that he subsequently insisted was taken out of context; a Federal Reserve statement seeing more price pressures ahead that would keep it on a consistent rate-hiking path; and most recently last Friday's nonfarm payrolls report that showed average hourly earnings jumped 2.9 percent on a year-to-year basis.

A swelling budget deficit, then, will only be tolerated by the jittery fixed income market for so long. There already was talk Friday of "bond vigilantes" staging a buyer's strike and pushing up yields.

With the Fed no longer buying Treasurys, losing a chunk of the private market would pose even more of a threat to yields, which move inversely to their prices. Higher yields, of course, also mean higher costs for all that government and private debt.

For the market, that takes out the key pillars for this bull market.

"Far from welcoming the additional boost to economic growth this year, the large declines in the
equity market this week suggests that investors are more focused on the prospect of significantly higher inflation as a result," the Capital note said.

The Capital economists say they expect the Fed to hike rates four times this year — one more than central bank officials themselves have indicated. It's a scenario that appears increasingly possible considering the hawkish rhetoric lately and sprouting inflation signs.