US reaction: September's fiscal furor deferred, but with it fiscal stimulus hopes

US reaction: September's fiscal furor deferred, but with it fiscal stimulus hopes

Market commentary
07 September 2017

David Page, Senior Economist at AXA Investment Managers (AXA IM), comments on the debt deal announced by President Trump yesterday.

Key points

  • A deal announced yesterday will extend the debt ceiling and government funding until 15 December, removing the risk of fiscal interruption this month.  
  • However, the agreement of a Continuing Resolution for the next three months further adds to the difficulties of passing a fiscal reform bill before the mid-term elections. We believe the chances of this are less than 50%.
  • We have reduced our 2018 GDP growth forecast to 1.9% in the light of reduced stimulus expectations.
  • We have also lowered our Fed Funds forecasts for 2018 and now see FFR closing this year at 1.25%-1.50% and next year 1.75-2.00%.

The clock was reset on the US’s fiscal time bomb for September yesterday. Following a House vote of 419-3 to pass $7.85bn for emergency relief funding to support victims of Hurricane Harvey, President Trump agreed to a Democrat deal to extending both government funding and the debt ceiling until 15 December, removing a month-end risk that both the US government may be forced to default on its obligations and separately that the government may shut down from 1 October. These risks are now deferred at least until year-end and for the debt ceiling possibly further into 2018. While this removes the risk of a fiscal event in September and resulted in a boost to financial markets (government bond yields, equities and the dollar higher), we argue this increases the headwinds to passing a ‘fiscal reform’ package before next year’s mid-term elections.

The details of yesterday’s agreement are still sparse and could shift over the coming days. We will monitor the upcoming Senate vote. However, there are a number of immediate consequences:

1) Debt ceiling deadline delayed. We do not yet know how the debt ceiling will be extended. Recent suspensions of the debt limit have seen it reinstated at a level including any interim borrowing. This effectively resets the Treasury’s ability to enact “extraordinary measures” to manage the cash balance, deferring the actual fiscal deadline into 2018 – possibly until the end of Q1. However, Congress can also increase the debt limit temporarily, seeing it revert to the lower level thereafter. The T-bill yield premia between October and September fell back on the announcement, but late-December yields rose, suggesting markets attach some probability to the latter approach. Forthcoming details over the debt ceiling extension should resolve this timing uncertainty. However, taking a step back, although we recognise that rhetoric and market volatility will rise around the time of the next debt ceiling expiry, we continue to view the consequences of Congress not raising the ceiling and triggering default as so serious as to deter it from following this course.
2) Continuing resolution passed. The agreement is also said to extend government funding beyond the end of this fiscal year to December 15 using a “continuing resolution”. This removes the fear of a government shutdown in October. However, passage of a spending bill in December may still be fraught, particularly if the President presses ahead with contentious elements like funding “the Wall” or increases in defence spending. A December shutdown would be possible, with politicians trading-off an unpopular Christmas shutdown against expectations of reduced economic impact at that time.
3) A Continuing Resolution does not facilitate fiscal reform. Republicans looked likely to enact fiscal reform through a reconciliation to Budget 2018. A 3-month Continuing Resolution does not allow for reconciliation. While it will be possible for lawmakers to work on reconciliation instructions and fiscal reform measures in parallel to achieving a Budget 2018, in practice we think this adds a further hurdle and delay to an already difficult process. Over the summer, the combined developments of changes at the White House and the Republicans inter-party difficulties in resolving healthcare had already led us to downgrade our assessment of the chances for a meaningful stimulus to below 50%. Yesterday’s agreement, including a confusion involving key fiscal negotiator, House Speaker Ryan, to our minds reduces those chances further.   

As a result of changing our outlook over the prospect of fiscal stimulus, we have lowered our outlook for US GDP growth in 2018 to 1.9% (consensus 2.3%). The scale of this slowdown should be softened in part by spending to help rebuild after this year’s hurricane damage. It will also depend crucially on the scale of next year’s inflation rise weighing on household real incomes and households’ associated decisions over saving. At this stage, we highlight additional downside risks to next year’s growth outlook.    

Yesterday’s decision does not alter our Federal Reserve (Fed) outlook, but reduces some risks to it.

The removal of September’s fiscal risks should remove any lingering doubts that the Fed will announce its balance sheet unwind at its meeting on 20 September, to commence in October.

We will watch the accompanying ‘dot’ projections in September expecting some participants to scale back expectations for a final rate hike this year. However, on balance, our expectation that ‘core’ PCE inflation will rise from July’s 1.4% over the coming months, should result in the Fed continuing with its gradual withdrawal of policy stimulus in December. Markets currently suggest only a 29% chance of a December hike today. 

We have reduced our expectations for rate hikes in 2018 to two from three, reflecting our expectation of slower growth next year and the slightly faster than forecast balance sheet unwind. By H2 2018, the Fed is likely to let most of its assets mature and we estimate this to be closer in equivalence to 0.50% of FFR tightening than 0.25%.

Markets posted some reaction to this news yesterday with 10-year government bond yields rising 4bps to 2.10%, the dollar up 0.3% against a basket of currencies and equities trading around 0.25% higher. Some of this reaction has been pared back overnight. More broadly, markets continue to be affected by geopolitical tensions with marked uncertainty how this will progress to end-year. Over the longer-term, our expectation that the Fed will not tighten monetary policy as much it suggested in June will add to market complacency over rates, which we envisage resulting in little change in long-term rates over the rest of this year. Moreover, a more gradual tightening next year has led us to reduce our expected 10-year yield target to 2.70% for end-2018.


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