The U.S. federal budget has a reasonable probability (our base case scenario) of reaching operational balance – revenues equal expenses excluding interest expense – by FY2015. This is an amazing turnaround and it means that budget deficit is now shrinking faster, meaning reduced supply of U.S. Treasuries, even as the Federal Reserve tapers its quantitative easing program, rendering any net impact on the bond market from QE-tapering as moot. Let’s put this shrinking deficit into perspective.
The U.S. federal budget deficit surged to just over 9 percent of GDP or about $1.4 trillion in FY2009, including interest expense. The messy bankruptcy of Lehman Brothers and the bailout of AIG in September 2008 had spooked financial markets. Under President Bush, then-Treasury Secretary Paulson had gone to the U.S. Congress for a trillion dollars of emergency spending. As this money was disbursed, the budget deficit ballooned. For some analysts, given the depth of the recession and huge job losses, it seemed that it could take a decade or more to return to fiscal stability. That negative analysis could not have been more wrong.
The U.S. economy has been growing in real GDP terms since late 2009. And despite losing over 850,000 jobs in the government sector, private job growth has been quite strong since 2010. Corporate profits have had a very robust recovery over the last several years, and the consumer has become more confident. So despite government retrenchment at all levels – federal, state, and local – the private sector has fueled surging government tax revenues. Inflows to the U.S. Treasury were up 8 percent in FY 2013 compared to FY 2012, for example.
If the U.S. economy can post growth above 3 percent in real GDP terms in 2014, as we think it can (see “U.S. Economy: Solid Momentum Entering 2014” , then tax revenues are likely to continue to grow at a healthy pace. In the meantime, a divided U.S. Congress and no major new spending legislation have meant that federal government expenditure growth has been virtually non-existent for the last few years. This is a powerful combination – robust tax revenue growth and flat expenditures – for deficit reduction. Our base case scenario is for about a federal budget deficit in FY 2015 of 1.5 percent of GDP, and since interest expense is likely to be in the 1.5 percent to 2 percent range, this translates into a balanced operational budget. The Congress Budget Office is not as optimistic, but one can expect revisions in their long-term projections should the economy stay as healthy as we hope.
For all this short-term good news, of course, the longer-term challenges to the U.S. federal budget coming from an aging population and a much slower growing labor force should not be minimized. Nevertheless, for those market participants trying to analyze what a the Fed QE-taper might do to bond yields, it is an interesting counterpoint to recognize that U.S. Treasury supply is actually shrinking faster than the Fed is reducing its purchases.