Interest rates up + US deficit up + inflation up (for now) = not a good situation

Yesterday had the release of the first US Treasury Statement of the new fiscal year, and it produced a nice round number that headline writers could easily lead with.

The U.S. recorded a $100.5 billion budget deficit in October, an increase of about 60 percent from a year earlier, as spending grew twice as fast as revenue.

The deficit widened from $63.2 billion in the same month last year, the department said in an emailed statement on Tuesday. October marks the start of the U.S. fiscal year.

Receipts totaled $252.7 billion last month, up 7 percent from a year earlier, while outlays climbed 18 percent to $353.2 billion, according to the department.

Some of this is a bit misleading, because payments were a little screwy in September due to the 30th (and the end of the Federal Fiscal Year) happening on a Sunday. If you dig into the Congressional Budget Office’s Monthly Budget Review for October, it shows the effects of this calendar trick.

The government recorded a deficit of $98 billion in October, CBO estimates, about $35 billion more than the shortfall recorded in the same month last year. A shift in the timing of payments affected the deficit in October 2017; if not for that shift, the deficit last month would have been $9 billion less than it was in October 2017.

And sure, the October 2017 numbers were also goofy due to weekends, but you get the idea. While the toplines are bad, we’re not likely to have a 40% increase year-over-year in the deficit for the entire 2019 Federal Fiscal Year.

But the deficit certainly is continuing to go up, and bond investor Jeff Gundlach notes that our rising budget deficit is outrunning the increase in the economy caused by deficit spending. He notes that this is making interest rates rise to keep pumping the money out and to slow down the economy.

“When the deficit goes up, it’s stimulative to the economy. That’s good in the short term, but it’s borrowing from the future,” he said.

On the chart, the blue line represents the Fed funds rate and the red line is the deficit. During the early 2000s, the red line and the blue line moved in the same direction. To put it another way, when the blue line goes down, the means the Fed cut rates, and the deficit expanded. Part of that can explained by a lousy economy that lowers tax receipts and increases government outlays, but there’s also generally some stimulus in there to help the economy pull out of that recession. The red line goes up during good a good economy because the deficit is supposed to shrink. The red line going up changed in the aftermath of the global financial crisis when deficits shrank while rates remained low.

“When the Fed started raising rates, very strangely, the deficit started rising because, of course, of the policies put in place in the aftermath and prior to the election. Now we see we are raising rates again while the deficit as a percentage of GDP is rising.”

Because our deficit keeps going up in a time of economic growth, Gundlach says the US economy is heading toward a self-perpetuating cycle where the rising interest rates themselves also increase the deficit by increasing the cost required to pay off bondholders.

“If you look at the screen of the yield curve today, the yield curve, it basically has a three-handle across the board and so those bonds, when they mature, will have to be replaced unless we have a budget surplus, which obviously is not the trend presently with higher cost debt. And so we’ll have yet another perhaps $150 billion or so of interest expense five years from now if interest rates are raised along in sync with the Fed’s stated plan to continue to hike rates pretty much at a quarterly rate.”...

“This is not a good situation,” Gundlach said, before adding, “It seems like we’re on a suicide mission by increasing our debt and increasing the cost of that debt simultaneously. I’m quite sure this is going to be an issue that’s going to be important within 5 years at the absolute maximum.”

One thing that could stop these increases in interest rates is if inflation gets held in check, as that would hold down the real rate of interest, which hasn’t changed all that much in the last 2 years because year-over-year inflation has doubled from 1 to 2.5% over the last 2 years.

Speaking of inflation, we just got a report today on the October Consumer Price Index. While that report showed a slightly-hot 0.3% price increase for last month, that included a 3% increase in gasoline that has sharply reversed since then (if you’ve gone to the gas station recently, you’ve likely noticed). Because that 0.3% monthly rate does not seem like something that will continue in the near future, maybe the concern about raising interest rates high due to keep up with rising inflation might subside in the near future.

Also in that CPI report, it showed food prices already have been dropping (down 0.1% in October), partially due to the surplus of products that are being kept in the country due to the Trump Trade Wars. That’s not good news for farmers (as evidenced by the 1,100 dairy farms that have gone under in Wisconsin since the end of 2016), but combine that with the decline that’s starting to happen with gasoline, and it likely will mean flat if not negative inflation for the coming months.

Of course, our deficit will still be putting upward pressure on rates, since we have to get more of our debt sold, as bond trader Gundlach noted this week, and that doesn’t seem likely to go away any time soon. And I wouldn’t count on massive economic growth to reduce that deficit, not in a time of sub-4% unemployment and real hourly wages declining in October (granted, it was only down 0.1% and 12-month real growth was up to 0.7%. Party hats!).

Which makes me wonder when the second shoe drops, and it’s not just crops and now oil and gasoline that have overproduction problems that deflate prices, destroy profits, and lead to layoffs. Logic tells me it’s sooner than later, and when it hits, we won’t have much fiscal flexibility to get out of it without a lot of pain.