Fiscal Policy in the Future

Recently, we've had the government in the headlines, with the debt ceiling approaching, government funding deadline at the end of the month, and the infrastructure bills being negotiated. 

Here is what gets investors in trouble.  Looking in the rear view mirror to try to predict what will happen in the future.  Especially when that rear view mirror only sees what happened in the past 2-3 years.  You need to look in the rear view mirror but put everything into context and have a rational perspective on trends.  

For example, the consensus view on fiscal policy is that it will be expansionary with growing budget deficits and huge fiscal stimulus far into the future.  An outlier event in 2020 has everyone thinking that the Covid policy response will be what fiscal spending looks like going forward.  Yes, the budget deficits will be big, but not as big as many expect.

You just happened to get the 2 most potent combinations for massive fiscal spending over the last 5 years:  1) First term Republican president.  2) Democrat president with both houses of Congress controlled by Democrats.  Those are the two combinations that lead to the most government spending for the following reasons:

1) A first term Republican president wants to keep the economy strong in order to get re-elected, so he wants tax cuts and increased government spending.  In the first half of Trump's presidency, he had a Republican majority in both Houses, allowing him to pass big tax cuts.  In the second half, he had a Democrat majority in the House, which led to big spending bills during the pandemic.  Democrats always favor more spending, especially Democrats in the House of Representatives, who have 2 year terms.  That forces a compromise on any spending deals to include tons of extra spending and Democrat lobbyist pork.  

2) A Democrat president with both houses of Congress is the most lethal combination for extraordinary government spending.  It is rare, because Republicans have a built in advantage in the Senate races because there are more Republican states which have a Republican majority voter base than Democrat states.  This due to rural states which are overwhelmingly Republican, and even if the population is low, they still get 2 Senators each.  Of course, Democrats prefer spending more than Republicans, but contrary to past Democrats, are less zealous about increasing taxes to fund increased spending.  This leads to huge spending bills funded by Treasury issuance which is bought by the Fed, basically MMT. 

However, starting from 2023, after the midterm elections, you are likely to see this change.  Like all past midterms, the party that is NOT in the White House is hugely  favored to win at least one of the Houses of Congress, due to voter motivation effects.  That means that Republicans are almost guaranteed to win either the House or Senate, or both.  That basically puts an end to Biden's profligate fiscal spending as a Republican majority in Congress will not sign off on anything to help the economy ahead of the Presidential election in November 2024.  

Suddenly, the consensus view of massive fiscal spending for years and years will be invalid, at least for 2023 and 2024, and perhaps even longer if the Democrats win the Presidency in 2024 and Republicans win at least one of either the House or Senate, which is likely, given their built in advantage in the Senate races.  In that case, that would be a repeat of the Obama years from 2010 to 2016, where fiscal budgets were constrained by Republican majority in Congress unwilling to sign off on more spending.  

Back to the market.

I am now hearing 1. rising yields, 2. debt ceiling uncertainty, 3. technical mumbo jumbo, and  4. Chinese power issues/Evergrande 5. supply chain worries as reasons to be bearish.  I agree about the rising yields, but none of the other issues.  And the stock market doesn't continue to sell off on rising yields unless it gets out of control like it did in 2018.  Not even close to that type of situation.  Debt ceiling will be raised, as it always has.  Technicals tell you what happened, not what will happen.  The more people that are bearish on the technicals, the better the buy set up.  Chinese electricity shortages are actually bearish for commodities not, stocks.  If factories can't run at full capacity, that reduces the demand for raw materials.  China has a much smaller effect on the US stock market than the commodities market.  Lastly, the supply chain issues that everyone talks about is primarily due to overseas Covid restrictions, which will go away eventually as cases go down and once governments realize that their policies are useless and doing more harm than good.  There is a shortage of labor, but some of that should be relieved with the expiration of unemployment bonuses.

We got the selloff that I was looking for, taking the SPX down to the Sep. 20,21 closing levels around 4350.  Thankfully giving those holding cash another buying opportunity.  I am basing my shorter term trading off longer term time frames and its still in the uptrend phase.  We are in the late stages of the bull market, but not the final stage in my view.  The 4300-4350 zone is turning into support during this consolidation phase.  In the short term, I expect more chop between 4300 and 4480, perhaps up to 2 weeks more.  After that, we should see a resumption of the uptrend as investors should reclaim their greedy view of the market, after taking a much needed break in September to refuel. 

With stocks up so strongly this year, fund managers will be motivated to keep up with the averages and I expect them to chase this market higher in November.  Much like September, investors fear October, but with the September pullback, its a much worse set up to follow seasonal patterns and expect October to be weak.  I took a partial long in SPX, looking to buy more in the coming days in the 4300-4350 area.  Although unlikely, I won't rule out an overshoot to the downside towards 4250.  If that move happens, I expect it to be brief and immediately lead to a panic low and V reversal. 

On the bond market, I've been too sanguine on the tapering fears.  I was surprised by how explicit and eager Powell seemed to get tapering started in November.   Its actually not the taper, but the pricing in and timing of rate hikes due to the taper that is causing yields to rise.  Now we know that rate hikes are on the table in late 2022.   Contrary to what a lot of bond "experts" say, a Fed signaling a taper and indirectly signaling a timing for rate hikes is not bullish for the long bond.  At the beginning of any tightening cycle, the long bond suffers the most because that's where there is the most duration risk.  People assume that a Fed rate hiking cycle will slow down growth and potentially lead to a recession, keeping 30 year yields lower in the future.  That's old fashioned thinking.  It doesn't work like that anymore.  We've got to change frameworks from the pre-2008 bond market to the Japanized bond market.  Rate hikes will be limited, if they happen at all.  Monetary policy is now mainly transmitted further out on the curve, because when you spend most of your time at zero Fed funds rate, but investors still fear future rate hikes, they move yields 3+ years out on the curve.  

A hawkish Fed is not bullish for the long bond.  If I owned 30 year Treasuries, I'd rather have a Fed that signaled that it would keep rates at zero for a long time than one that threatened rate hikes.  There is a limit to how steep the yield curve can get when Fed funds rates are constantly kept at zero.  This keeps the 30 year Treasury yields contained.  People are not complete idiots.  They eventually figure out the pattern and price in zero rates for longer and longer periods of time into the future (e.g., Japan, Europe).  

Treasuries are a tough trade here, tough to be long with the November Fed meeting still ahead and a likely tapering announcement, but it seems like so many are leaning short in the market and its already sold off quite quickly in the short term, so don't think shorting is the play either.  Plus, negative carry makes it harder to profit on the short side except for very short term trades.