The risk is growing that Corporate America soon will be starved of the fuel it needs because of federal government borrowing to cover deficit spending. And Washington has made those deficits bigger with recent tax and spending deals.
“The worry is that over time, the more the government borrows, the more demands the government places on a limited pool of savings, the more it will potentially crowd out some private, productive investments,” Joshua Feinman, chief economist at Deutsche Asset Management, told the Washington Examiner.
Already, the U.S. Treasury’s outstanding public debt of $14.2 trillion at the end of September accounted for a big portion of the $40.3 trillion bond market and dwarfed some $8.7 billion in corporate debt.
The Treasury is likely to have to increase the interest rate to attract buyers to the bonds it must issue to cover $1.5 trillion more debt created by the tax cuts Congress passed in December and a further $320 billion due to a spending agreement this month.
Economists agree that this creates a twofold challenge. Because federal securities are widely viewed as the safest form of debt, so higher rates on government paper would prompt some investors to sell their corporate bond holdings to buy Treasury instead.
To compensate, American companies would probably have to pay higher interest rates themselves. As with credit cards, those who could least afford to do so, the people with the worst credit, would have to pay the most. And all corporate borrowers would get a smaller bang for their buck.
To be sure, economic growth that President Trump and Republicans hope will flow from the tax overhaul would ease some risks in the short-term.
The top rate corporate income tax rate is now 21 percent, compared with a previous 35 percent, so American companies will need to borrow less. They can also use cash they have overseas, which carries no penalty under the new tax law other than a one-time levy of 15.5 percent.
Both of these factors mean it is less likely that crowding corporate borrowers out of credit markets will become an problem in the immediate future, Mark Cabana, rates strategist with Bank of America Merrill Lynch, told the Washington Examiner.
“It’s a dynamic that could play out over time,” he said. “As the amount of Treasury supply increases and the interest goes higher, that’s going to eat into the pool of capital that would have been available to support corporates, given that Treasury is going to be absorbing a larger piece of that.”
The trend will probably be made worse by the Federal Reserve shrinking its balance sheet again after nearly quadrupling it to $4.5 trillion during years of buying government securities to increase the money supply and prop up the economy in the wake of the 2008 financial crisis.
Rather than selling the securities, the Fed decided as Chairwoman Janet Yellen neared the end of her term in September that it would gradually reduce the amount in reinvested in securities as older securities matured.
The so-called rolloff began with a cap of $10 billion a month that will eventually rise to $50 billion. Goldman Sachs predicts the strategy will ultimately trim about $1.5 trillion from the Fed’s balance sheet.
For each dollar the central bank shaves off, though, “the U.S. Treasury has to issue another dollar in the open market in order to raise cash to pay back the Fed,” noted Bank of America’s Cabana. “That just worsens the overall supply backdrop.”
At the same time, it demonstrates why it is desirable to get federal spending more in balance with income. This was something that White House budget director Mick Mulvaney fought for when he was a House lawmaker representing South Carolina, but which he conceded isn’t being done with Trump’s budget proposal that was rolled out last week.
Instead, the plan, which Congress is likely to ignore, proposes widening a deficit of $665 billion at the end of last year to $987 billion by the end of 2020 before beginning to shrink it again. It would create deficits of $7.1 trillion over the 10 years through 2028.
“As a member of Congress,” Mulvaney admitted to the Senate Budget Committee this month, “I would have found enough shortcomings with this to vote against it.”
Chris Krueger of the Cowen Washington Research Group put it more bluntly: “Trump’s budget delivers the final death nail into the former GOP deficit-hawk mantra,” he wrote in a report. He also noted that the two-year spending deal, which Trump supports, will have far more bearing on government action.
The agreement, which raised spending caps by $300 billion over the next two years and suspended the debt limit, prompted Bank of America to raise its deficit forecast by 4.4 percent to $825 billion in 2018 alone.
Treasury borrowing will probably be $441 billion in the first three months of this year, double the average over the past five years, and $176 billion in the second quarter, which is far more than the $8 billion which is typically borrowed as tax revenues roll in as taxpayers complete their returns in the run-up to the April 15 filing deadline.
Since that tends to push up rates, which was the concern that prompted a massive sell-off in stock markets in early February, it necessarily “raises risks for tighter overall financial conditions,” Bank of America’s Cabana and his colleague, economist Joseph Song, wrote in a report.
The U.S. Chamber of Commerce’s chief economist, J.D. Foster, remains more sanguine, however.
“Businesses, like most American people, have become somewhat immune to large deficits because there doesn’t seem to have been much of a consequence,” he told the Washington Examiner.
The federal debt surged under former President Barack Obama without having a significant effect on interest rates or crowding out borrowers, Foster pointed out.
“If you believe that at some point, there’s going to be a limit to how much that debt can rise without consequence, then you start to get nervous,” he said. The argument isn’t particularly compelling right now, however, because federal debt almost doubled under President George W. Bush and more than doubled under Obama, yet interest rates on the 10-year Treasury note are still below 3 percent while inflation is running at 2 percent, netting bondholders growth of 1 percent or less.
“At some point, we’re going to be able to say, ‘We told you so,’ ” he added. “But at the moment, we’re not very credible.”
