The split between US President Donald Trump and technology leader Elon Musk will cause Republicans huge problems. Mr Musk may not be everyone’s cup of tea. But on one critical issue – fiscal responsibility – the founder of SpaceX and Tesla is correct. Cutting taxes and pushing the Federal deficit up sharply will backfire.
The US president may ostensibly point to the CBO’s assessment of the tax-cutting bill. Yes, the deficit will go up (by around $2.4tr). But this will be cancelled out by the revenues raised from tariffs. The net impact will be zero. However, it seems implausible that a policy that will do severe damage to the economy, and invite extensive retaliation, will generate revenues to match the costs of Trump’s side-supply experiment.
The bond market reaction will be more pronounced if investors sense inflation is once more on the rise. Cuts to immigration and the expulsion of workers will make the bond markets nervous too. Job creation may slow, but the jobless rate will remain close to what the FOMC has previously termed ‘full employment’.
The term premium in the US Treasury market will continue to rise, particularly if Republicans defy Elon Musk and pass the tax cuts. And without a fall in longer-dated yields, FOMC members will be hard-pressed to accept the case for a lower Fed Funds rate. They will know too, that politically motivated rate cuts to appease the inflationary fallout of tariffs will steepen the yield curve. Kowtowing to Trump on monetary policy may damage the economy, pushing the baseline for Federal deficits higher: and put even more upward pressure on bond yields.
For years, there has been a presumption that slower economic growth leads to a rally in debt markets. That does not hold when politics dictates monetary policy, and when politicians use interest rate cuts as a bailout for economic mismanagement.
