Fiscal and Treasury financing outlook steady for now

| April 26, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

The current Treasury borrowing calendar looks sufficient to meet the government’s needs for the next 12 to 18 months, presuming increases over time in bill supply will absorb the impact of a moderately widening deficit. Beyond FY2020 outlays are projected to advance at an accelerated 6%-to-7% clip on average, outpacing revenue gains in an environment of lower real growth. This will transform a modest financing gap of less than $100 billion in FY2020, into a yawning shortfall of over $400 billion in FY2021.

2019 federal budget outlook

Most of the excitement in the federal budget outlook is behind us for the time being.  The near-term impact of the 2017 tax reform and the 2018 deal to hike discretionary spending should be fully embedded in the actual numbers, especially now that the April 15 tax season, the first under the new tax code, is almost completely in the books. Chances are that the rancorous atmosphere in Washington will prevent further significant legislative initiatives, so the deficit going forward will mostly be determined by the health of the economy and, in turn, tax receipts. Treasury financing should also become more straightforward with the Fed winding down its balance sheet reduction program, resulting in no major changes to the issuance calendar for the next year or so.

FY 2019 Outlays.  Through the first half of the fiscal year (October to September), outlays are up by 4.9% versus the corresponding year-ago period. Entitlement spending is up and interest costs continue to balloon, but the primary driver at this point may be a steep rise in discretionary outlays. Defense spending was up nearly 9% on a year-over-year basis from October through March.  Last year, a calendar quirk depressed entitlement spending at the end of the fiscal year, so a return to the normal pattern will boost the increase in outlays for the year.  All-in projections are for a big gain, perhaps more than 7% for the year, which would be the fastest advance since 2009.

FY 2019 Revenues.  The tax cut probably had close to its full effect on corporate tax receipts in 2018, since businesses generally pay taxes quarterly and quickly began to take full advantage of the various breaks that became available to them, such as full expensing on investments.  In contrast, withholding tables for individuals only changed in February, over a third of the way through fiscal year 2018, and April 2018 tax payments reflected 2017 liabilities. Individual income tax receipts are likely to underperform relative to the speed of nominal GDP growth in FY2019 (ordinarily, in a strong economy, individual tax revenues would increase a little faster than nominal GDP gains), while corporate income and payroll tax receipts may bounce back to solid growth going forward. Fed remittances continue to decline substantially as the Fed’s balance sheet is shrinking.  In total, federal revenues are projected to rise at about a 3% clip in FY2019, a vast improvement from FY2018’s 0.4% advance, but still well behind the growth in the economy.

Withheld individual income tax receipts ran well below the corresponding year-ago period in the first six months of the fiscal year, as the new withholding tables did not go into effect until February 2018.  Now that year-over-year comparisons are fully past the change in the tax code, going forward, withheld individual income tax receipts should resume solid year-over-year growth.  In this tax season, tax refunds are running just below year-ago levels, far better than some had feared when the refund figures got off to a slow start due to the government shutdown, as discussed in The truth about tax refunds. The nonwithheld receipts from the April 15 tax deadline are running very close to year-ago levels with about a week of substantial flows remaining.  Corporate income tax revenues were similarly down on a year-over-year basis from October through March but should begin to post growth versus year-ago going forward, as the April month-to-date tally has already exceeded the take for all of April 2018. Payroll taxes, which are largely unaffected by the tax reform changes, posted a 4.7% increase in the first six months of the fiscal year versus the corresponding year-ago period.

FY2019 Deficit.  The budget deficit may rise in FY2019 to around $985 billion, slightly higher than the estimate from three months ago.  Relative to January projections, this shaved about $15 billion off of revenue estimates and bumped the outlay forecast up by about $5 billion.  The FY2019 forecast could yield a deficit-to-GDP ratio of 4.6%, up from 3.8% in FY2018, and would be the highest reading since 2012.

Budget outlook for FY2020 and beyond

The combination of accelerated increases in discretionary spending on the back of the 2018 deal to ramp up defense and domestic appropriations, an arrangement that is likely to be largely extended for the next few years, upward pressure on entitlement spending due to the retirement of the Baby Boomers, and the steep increase in the government’s funding costs after the Fed moved monetary policy back toward normal is pushing federal spending relentlessly higher.  Over the next three years outlays are projected to advance on average at a 6%-to-7% clip.

On the revenue side there is far more optimism about the medium-term economic outlook, based on expectations of solid growth and rising inflation. Nominal GDP should rise faster over the next few years  – in a 5%-to-6% range rather than a 3%-to-4% range – due in part to the boost from tax reform.  Even so, in an environment of slow real growth by historical standards, it is doubtful that revenue gains can keep up with the steep trajectory of spending, even with the assumption that the 2017 tax reform has some lasting beneficial impact on the economy.

As a result, the federal budget deficit will swell to about $1.07 trillion in FY2020, about $25 billion larger than the forecast from three months ago.  Looking even further ahead, I expect the FY2021 deficit to rise to about $1.16 trillion, roughly $35 billion more than previously projected.  As a percentage of GDP, these deficits would be over 4½%, unsustainably high but well below the readings in the first few years after the financial crisis. Looking further out to 2022 and beyond, there is little reason to expect substantial narrowing of federal budget deficits, though if the economy remains healthy, it is possible that the red ink could inch lower as a percentage of GDP.

Treasury financing outlook

The Treasury ramped up coupon issuance sizes for a year beginning in February 2018 until it halted those hikes at the February 2019 refunding announcement.  Over that 12-month period, the bulk of the increases occurred in the short end of the curve (three years and in).  Monthly two-year and three-year note auction sizes were boosted by $14 billion, while sizes for 5-year securities were raised by $7 billion and longer coupon securities were nudged up by only $4 billion each.  Over that same time period, Treasury bills were also beefed up aggressively, including the introduction of a new 8-week bill tenor and a significant hike in 2-year floating-rate note (FRN) sizes.

One of the primary forces that necessitated such an aggressive strategy from Treasury debt managers was the Fed’s balance sheet normalization.  Beginning in late 2017, the Fed has been running off its Treasury holdings pretty rapidly, requiring Treasury to borrow more from the public to fund the government’s financing needs.  Over the past six quarters, the Fed has run off $280 billion in Treasuries, resulting in a dollar-for-dollar hike in Treasury borrowing from the public.  The Fed has announced that it will be winding down its redemptions over the next six months, running off another $100 billion or so in securities before ending its balance sheet reduction program.  The end of this initiative dramatically alters the Treasury’s financing requirements going forward.

The current Treasury borrowing calendar looks sufficient to meet the government’s needs for the next 12 to 18 months, presuming modest increases over time in bill supply.  Based on deficit projections, Treasury should be in good shape through the balance of this fiscal year and well into FY2020.

However, the current lull may prove to be a brief respite.  In 2020, the increase in auction sizes for 2-year notes (and FRNs) put in place in 2018 will mean that the Treasury will find itself with an accelerating pace of maturing securities to replace, a dynamic that continues in 2021, when larger 3-year notes also begin to mature.  As a result, the flow of maturing coupons is likely to rise by over $100 billion in FY2020 from FY2019 and then by a whopping $250 billion or so in FY2021 from FY2020.  With deficits rising AND the flow of maturing debt increasing, Treasury debt managers are likely going to have to initiate a second round of significant coupon auction size hikes sometime in 2020.  Assuming steady moderate increases to outstanding Treasury bill supply, projections are for a modest financing gap in FY2020  of less than $100 billion, but a yawning shortfall of over $400 billion in FY2021.

john.killian@santander.us 1 (646) 776-7714

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