How Fiscal Dominance Matters for Investors (November 11, 2023)

As the Treasury encroaches on the Fed, inflation will persist and politics may have a bigger impact on markets. 

Risks around fiscal dominance–the idea that government spending can compromise a central bank’s ability to fight inflation–are growing more concrete with real implications for investors. 

Two events during the past week underpin concerns over the U.S. fiscal situation. First came credit-rating firm Moody’s downgrade of the U.S. outlook to "negative" from "stable,” with Moody’s citing large fiscal deficits, a decline in debt affordability due to rising interest rates, and political polarization exacerbating fiscal problems. 

Another credit downgrade, should Moody’s take that step, may not immediately bite in ways investors might expect.  As Jim Bianco of Bianco Research notes, the downgrade of the U.S. credit rating by S&P in 2011 was a shock as many financial contracts specified that collateral had to be ‘AAA’-rated. Since that initial downgrade, Bianco says most of those contracts have been rewritten to include “AAA or debt backed by the U.S. Government,” or similar language to that effect. 

The warning is nonetheless worth heeding, particularly as it came a day after another poor Treasury auction. The $24 billion 30-year bond sale was “breathtakingly bad and just short of catastrophic,” says newsletter writer and former hedge-fund manager James Lavish, with a bid-to-cover ratio of 2.24. 

That is a “C or C-, if this were graded as a test,” says Lavish, down from a recent norm of around 2.4 that is already lower than pre-Covid levels because of shrinking foreign demand for U.S. Treasuries. With foreign demand down sharply from even a month ago and institutions and individuals failing to pick up the difference, primary dealers were left with a quarter of the issuance–more than double their average in recent 30-year auctions, notes BMO Capital Markets. 

Taking the credit-outlook cut and another poor bond auction together, a few takeaways seem particularly salient. 

First, the gap between the government’s debt and the share absorbed by the Federal Reserve continues to grow. Thus the Fed will inevitably need to return as a buyer of last resort, says Jurrien Timmer, head of global macro at Fidelity. 

“The fiscal side of the house is on a seemingly unstoppable track, which could leave the Fed trying to thread a needle—counteracting that fiscal dominance through policy restriction, while potentially also supporting it through market-stabilizing bond purchases,” says Timmer. 

Second, the Treasury announced in May plans to implement a regular buyback program in 2024. It is the first such program in over two decades and should help markets function at a time when liquidity concerns abound. As SMBC Nikko Securities chief economist Joseph LaVorgna notes, the issue of evaporating liquidity in the $26 trillion Treasury market is worse than in March when regional banking woes forced the Fed to increase bank reserves by nearly $400 billion. 

While such buybacks may aid liquidity and market operations, they are a tool that gives the Treasury more direct influence and opportunity to encroach on the Fed, says Joseph Wang, CIO at Monetary Macro and a former trader on the New York Fed’s open markets desk. 

Wang explains it this way. The buyback program appears modest, starting with just $30 billion a quarter in purchases made for liquidity support and $120 billion in first-year buybacks made for cash management purchases. But it allows the Treasury to both add and remove duration, a significant development because removing duration from the market has been up to the Fed and done via quantitative easing.

Treasury has said it wouldn’t modify the maturity profile of its debt with buybacks, but Wang says the program gives it the capability to do so. 

“For now they’re clear that they won’t change duration. But once these programs exist, they grow and they change,” Wang says. One worry: An administration worried about an election could effectively ease financial conditions by issuing short-dated debt to purchase longer-dated debt.  

Fiscal dominance isn’t a new concept. But as Gray Howard, senior portfolio manager at UBS notes, the last time the U.S. reached the current level of fiscal involvement was in the 1930s and 1940s, in response to the Great Depression and too long ago for most current investors to have experienced. 

To Howard, tough talk in Washington about deficit reduction is simply performative, with other central banks fully aware that the U.S. is attempting to inflate its way out of its conundrum. He offers two bits of advice for investors. 

First, Howard rejects the notion that stocks are risky and bonds are safe. Given where we are in the cycle, and as the U.S. tries to inflate its way out of a fiscal mess, stocks, real estate and commodities are probably better stores of value as compared to bonds, he says.

Second, follow the money. “In a world of fiscal dominance there’s a long line of lobbyists and CEOs in Washington with their hands out ready to catch a piece of the trillions and trillions of dollars flowing through the city,” says Howard. 

That is a comment ripe for more research and reporting. For now, we will leave you with takeaways from a quick scan of top spenders as tracked by Open Secrets, the nonpartisan platform tracking money in politics. 

Topping the list of top lobbyists by money spent this year, after the U.S. Chamber of Commerce and the National Association of Realtors, are insurance, pharmaceutical and hospital groups. Individual companies spending the most on lobbying include Amazon (ticker: AMZN), Meta (META), Pfizer (PFE), General Motors (GM), Alphabet (GOOGL), Boeing (BA), Amgen (AMGN), and CVS Health (CVS). 

The fiscal situation in the U.S. will get worse before it gets better. The implications are broad and just starting to unfold.