Welcome to the Thoughts on the Market. I'm Michael Zezas, Head of Public Policy Research and Municipal Strategy for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the intersection between U.S. public policy and financial markets. It's Wednesday, June 16th, at 10:30 a.m. in New York.
This week, we turn our attention back to the discussions in Washington, D.C. on infrastructure. The upcoming week is setting up to be a consequential one. That's because of media reports saying the White House will determine which way negotiations on infrastructure are to go: the bipartisan route, or the Democrats-only route. And that matters quite a bit, particularly if you're a fixed-income investor.
Let's break it down. The contours of the bipartisan infrastructure deal that appears to have a fighting chance is one that spends about $700 billion dollars and is fully funded through re-purposed funds, gas taxes and other yet-to-be determined ‘pay-fors’. In short, it would be a plan without much impact to the deficit. That could lend credibility to the idea that recent strong inflation data will only be temporary by taking away that risk of a big pickup in net demand from government spending will cause the prices of goods and services to continue rising at an above average pace. And inflation as a temporary trend rather, than an enduring one, would be music to the ears of bond bulls, helping yields move lower in the short term.
But in our view the bipartisan negotiations are more likely to break down than succeed. The parties are far apart on levels of spending and types of taxation. Moreover, it's unclear there would be enough votes among Democrats for a bipartisan deal unless it includes greater spending on environmental issues, which at the moment do not appear to be represented in the bipartisan outline.
And if there is a breakdown, the bond markets could take notice, reflecting the state of play with fresh price volatility. That's because the negotiation would pivot to a ‘go big or go home’ situation where the legislative outcome will appear to fluctuate between the big, deficit expanding deal, and no deal at all. Failure is increasingly an option, particularly if policy disagreements between moderates and progressives run too hot and drag the process into next year-- an election year. And even if these disagreements don't derail a deal, there are sure to be moments where it will seem like they will. That could certainly create downward pressure on Treasury Yields, given the view from our rates strategy colleagues that the market, following its first quarter selloff, is largely reflecting the expectation of a major deficit expansion from stimulus.
But as we've covered before, our base case is that we will end up with such an expansion. That's because the deal that could pass through a Democrats-only process would have to satisfy every corner of the Democratic Party given their slim majority. $2-4 trillion dollars of fresh spending appears to be in consensus, but quite a bit less in terms of tax increases appear supportable. But we think that gap can be bridged by deficit expansion. Democratic economists support the notion, polls show voters aren't particularly worried about deficits, and the White House appears ready to justify the fiscal soundness of its infrastructure plans by pointing out that the permanent tax hikes will eventually offset the temporary spending increases. In short, a meaningful deficit expansion in the near-term enables all Democrats to get what they want out of this plan. This is what's baked into our colleagues' view of why Treasury yields will end the year higher.
So these are the stakes, and this is why infrastructure headlines are worth tracking. We'll let you know if it means we need to start thinking differently about where bond yields go from here.
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