Budget Blues

The views expressed here may not reflect the GlobalData TS Lombard House View

◼ Loss of tariff revenue ends offset to the drop in corporate tax revenue, worsening the deficit, and the deficit is about revenue ◼ Core budget outlays are growing more slowly than GDP (FYTD), interest payments are not ◼ Tsy Bill demand is there – MMFs, large banks (now holding more UST than reserves), and the Fed – but who buys the coupons the Fed is not rolling? ◼ Is this Warsh’s tightening? Term yields do matter more than short rates The 10Y Treasury is on its way to 5% (last seen in Nov 2023) with an intermediate target of 5.4% and, as I have long been writing, a 6% target in 2027. Returning to an 8% yield, last seen in 1995 when this rate flipped from floor to ceiling, is also out there -- but that’s getting a bit ahead of the story. Warsh has wanted a return to the 1990s economy, and he is about to get the yields but not the real growth. Back during his college days, 5.5% on the 10Y was a trading bottom not a top. It took LTCM and then the dot.com bust to break this floor for good. Since then, 4% became the centre of gravity until Bernanke, the previous Fed Chair to revolutionize how the central bank operated, forced the 10Y to trade below neutral (2% real + 2% inflation) for 16 years, with only inflated risk-assets to show for his efforts. With inflation settling in around 3%, 5% appears neutral. No matter the calculation, yields are normalizing and risk assets are forced to adjust – something I have been writing about for a while. Markets, however, never just trade to the appointed level and stop. The overshoot to come will be driven by a worsening fiscal position and a Fed Chair happy with only the left side of the decimal point, while the capex-led economy needs to be funded by the rest of the world. The potential counter to this move – whether equities can manage to stay afloat as it reprices to a higher interest rate environment.

This most recent downturn in the bond market comes out of belated recognition of a poor fiscal outlook combined with recognition that the Fed will only hike after the return-to-2%- inflation thesis gets proven wrong (too late!). Yen intervention was the signal that the budget deficit, now deteriorating more rapidly without tariff revenue, could ill afford the world shying away from owning an increasing volume of US debt, when monetary policy suggests they should. For the moment, there are sufficient domestic sources to take down bill issuance (thanks to the Fed), but Treasury needs others to buy coupons that the Fed is not rolling into as its notes and bonds mature. Cue the steepening curve.

Budgets can be cut in any number of ways to make a point, but simply put, this budget deficit was about $100bn better FYTD at the end of May than a year ago, despite corporate tax revenue

being $90bn worse (tax cuts!). The offsetting factor was customs duties running near $110bn above the prior FYTD. Then came the Supreme Court decision (correct to my thinking, but I always wrote that Trump should’ve done the hard work of legislating rather than imposing these tariffs). As of the end of July, tariff revenue was $170bn to the worse. With that, the deficit is now even with year ago FYTD and likely worsen as the corporate tax revenue shortfall grows as the fiscal year comes to a close in September (Figure 1).

Chart 1: Loss of tariff revenue reveals the corporate tax cut’s impact on the deficit Y/Y Actual Change for Cumulative FYTD value

Budget Deficit Corp Tax Receipts Customs Duty Receipts 200,000 150,000 100,000 50,000 0 -50,000 -100,000 -150,000 -200,000 Oct Nov Dec Jan Feb Mar Apr May Jun Jul Source: US Treasury, GlobalData. TS Lombard

The focus is on revenue because outlays, excluding interest payments, have a Y/Y growth rate (4,3%) running behind nominal GDP (6.5%). (Chart 2). Whether it does through fiscal year end remains to be seen – especially with the latest reconciliation bill adding to defence spending.

Chart 2: Outlays ex interest growing but slower than GDP -- good news for now Y/Y %Ch of Cumulative FYTD spending

2026FY / 2025FY 2025FY / 2024FY

Oct Nov Dec Jan Feb Mar Apr May Jun Jul

Source: US Treasury, GlobalData. TS…