A Budget Buster

Based on Trump's tax plan, there is no way the Republicans can stay within their budget guidelines of $1.5 trillion more debt over 10 years.  Politically, most of those deductions have no shot of getting eliminated, with the power of Washington lobbyists behind them.

But the bond market thinks that there will be huge debt fueled tax cuts. For Treasuries, it seems like shoot first, ask questions later at the moment.  This is definitely a budget buster, and will increase Treasury supply enormously over the next 10 years. With the trend of higher mandatory spending for Medicare and Social Security as the baby boomers retire, you could see $2 trillion annual deficits.  Without a QE, that will roughly quadruple the size of the Treasury coupon auctions.  And there is no way that much supply is taken down at these yield levels without a recession.

That is based on the premise that Trump gets everything that he's asking for.  That's probably unlikely, even though the Republicans are desperate to pass anything to save their hides in 2018 elections.  Most likely, the tax cuts get watered down, with no deductions removed, and the corporate tax rate gets cut modestly and you get a little increase in the standard deduction.

But the bond market is hating the uncertainty of a possible whopper of a tax cut passing, and with ECB tapering coming up in late October, a suddenly hawkish Yellen, and VIX hovering around 10, it is fragile times for bond investors.  Once the dust settles, you should get to lower bond price levels which should hold up, but the question is how much lower.  Worst case scenario, if the SPX keeps making new highs till year end, we could revisit 2.60% 10 year yields.  More likely, I think we get up to 2.40-2.50% and find a top there.

In SPX land, the realized volatility is at 3 over the past 10 days, compared to a VIX around 10.  So even at a VIX of 10, vol is actually expensive here!  Just horrible for the ES day trader.