The Trump Administration Budget And Government Bond Yields

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by: John M. Mason
Summary

If the assumptions for growth, etc., built into the Trump budget are achieved, longer-term government bond yields should be much higher than they are, which would lead to larger deficits.

If the assumptions for growth, etc., currently built into the financial markets are correct, then forecasts for government revenues are inflated which would lead to larger deficits.

Conclusion, it appears as if the deficits of the Trump budget now in front of the US Congress are badly underestimated, meaning that government debt will be rising more rapidly.

Let’s assume that the US Congress passes the Trump Administration budget and things work out pretty much as the builders of the budget assumed.

Well, use this as a starting point to work out the implications of the budget as it has been presented.

To achieve this budget, it was assumed that economic growth average 3.0 percent per year over the next decade would. The decade would start out with the economy growing at a 3.2 percent rate, dropping to a 3.1 percent rate in 2020, 3.0 percent in 2021, and 2.8 percent in 2022.

Inflation was assumed to come in around 2.0 percent, the target objective of the Federal Reserve System

No recessions are projected.

Moving on to the government bond market. It is often assumed that the nominal yield on US Treasury securities is composed of two components, the expected real rate of interest and the expected rate of inflation

The expected real rate of interest is empirically related to the expected real rate of growth of the economy.

So, with the information we have from the Trump Administration budget we can build a picture of what the nominal yield on US government bonds should be.

Well, we have the explicit assumption given us that economic growth is to be around 3.0 percent per year over the next ten years.

Now, the expected real rate of interest is usually estimated to be something slightly below the expected real rate of growth of the economy, so if we assume that the expected real rate of interest is only two-thirds of the expected growth rate, we can assume that the expected real rate of interest is 2.0 percent.

Then if the expected rate of inflation is assumed to be 2.0 percent, the Fed’s target, then adding the two components together we come out with the conclusion that the nominal yield on the 10-year US Treasury security should be 4.0 percent.

Yesterday, at the close of the market, the yield on the 10-year US Treasury note was 2.64 percent. Quite a difference.

This raises a question about the budget figures. What is the assumption about the interest cost of the government’s debt built into the budget numbers?

If lower numbers are being used to estimate the government’s budget deficit, then the deficit is underestimated over the next ten years bringing the outstanding government debt to a much higher level than is not built into the proposal,

And, given the 3.0 percent expected rate of growth of the economy, what if the expected real rate of interest comes in at 2.5 percent?

Then you would have a nominal yield on the 10-year Treasury note of 4.5 percent. This would only make the budget matter worse.

But, then another question comes to mind. How do the expectations built into the government budget compare with the expectations now incorporated in market rates of interest.

Yesterday, as I mentioned above, the yield on the 10-year Treasury note was 2.64 percent.

In breaking this yield up into its components we have the expected real rate of interest assumed to be 0.73 percent. Here we use the yield on the 10-year US Treasury Inflation Protected securities as a proxy for the expected real rate of interest,

Given this assumption, we calculate that expected inflation is at 1.91 percent.

So, we see that expected inflation is just about what we are assuming is built into the Trump budget numbers, but the expected rate of real growth of the economy is substantially below that of the budget assumptions.

If, as in the example presented above, we assume that the expected real rate of interest is two-thirds of the expected real rate of growth of the economy, then this would work out to an expected real rate of growth of the economy of 1.10 percent.

If the expected real rate of interest is one-half of the expected real rate of growth, then the expected real rate of growth of the economy would work out to be 1.46 percent.

We can conclude from this that current market participants are not expecting the US economy to grow anywhere near the growth rates used to build the Trump budget estimates.

And, if the growth of the economy is much less than the assumptions used to estimate Treasury revenues, then the revenue projections might be brought into question.

This raises another question about the size of the federal government deficits going forward.

This is a simple exercise, but one that, I believe, is necessary to judge whether or not the budget is built using consistent assumptions.

In this present case, participants in the financial markets are expecting in the future, the US inflation rate to be very close to what the Trump administration has built into its budget assumptions.

However, there is a wide difference between the growth rates built into the budget model and the growth rates many in the financial markets believe will be achieved.

In either case, however, the conclusion one can draw from this exercise is that the budget deficits in the future are being underestimated. And, in either case, the government debt outstanding will rise by an even greater amount than what is now in the budget.

If the Trump administration is correct and we get faster growth, government interest rates will be higher than now projected and this will raise budget deficits.

If the Trump administration is wrong and we get slower growth, government revenues will be less than now expected and this will raise budget deficits.

This is only part of the world we are moving into when it comes to the current economic policy of the federal government.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.