US Fiscal Talks Steer Towards Frugality Risking to cap T-bond Gains

US Fiscal Talks Steer Towards Frugality Risking to cap T-bond Gains

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So, here we go. Some Democrats and GOP members are no longer convinced that the economy needs a large fiscal aid package, a senior White House official told Reuters on Tuesday.

According to the official, there are signs of growing bipartisan bias towards frugality, both in the House of Representatives and in Congress, when it comes to discussing the size of the aid. It can be now reduced to $500 billion which is at least twice less than discussed before. The way how the government will spend may be less stimulating in terms of consumer spending boost since the funds are expected to be directed to financing US Postal Service and payroll loans for small and medium-sized businesses. It means that stimulus checks and extended unemployment benefits, which significantly spurred consumer spending in May-July, may not be included in the new package.

As we discussed earlier, stalling progress in fiscal talks increase the risk of markets being wrong in pricing in the final size and timing of the deal. With new details from the US administration official, the likelihood of this outcome increased.

Why should investors be bothered about that? Let’s explore the chain of the effects.

Firstly, size of the fiscal package has a direct bearing on how much the government would need to borrow. It is clear that more spending means more borrowing and vice versa. The level and intensity of borrowing will determine the flow of a large portion of bond supply to the Treasury market and it is not known whether the market will be able to absorb it without the help of the Fed.

Therefore, bond-buying plans of the Fed may depend on how actively the government would need to tap the Treasury market. Open market operations of the Fed have direct impact on the flow of liquidity in the banking system (bank reserves) and increase of money stock. Expectations of aggressive bond-buying (in case of large fiscal package) may ignite concerns about expansionary monetary policy what means rising pressure on real yield as well as supply of USD which have direct implications for risk assets (bonds vs. stocks story) and USD exchange rate (greenback supply/demand story).

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