by Gene D. Balas
A rhetorical question – but not a prediction – what if the new administration’s stimulus plans, if approved by Congress, have unintended consequences? There is much that needs to be fleshed out in coming weeks and months, but the market has already cast its verdict on the plan, with a spike in yields on government bonds recently and a jump in inflation expectations embedded in TIPS pricing. Equity markets, likewise, are banking on more assertive growth, at least for now.
But what if the risks come from within, that is, from the very stimulus itself? Setting aside the separate discussion of trade policies, we’ll discuss two primary channels through which the increased budget deficits that would come from a large stimulus program can dent the economy. These include the effects of:
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higher interest rates, and
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a stronger U.S. dollar.
Inflation, interest rates and currencies
As it is, yields on the 10-year U.S. Treasury note jumped by roughly 45 basis points or so following the election, according to Dow Jones data. The Wall Street Journal U.S. Dollar index surged about 2.8% in that period.
However, both the dollar strength and the rise in interest rates are intertwined, as higher rates often lead to a stronger currency. Rates tend to rise through some combination of higher inflation expectations and a greater amount of supply relative to demand for bonds, such as when budget deficits are increased substantially (as would be the case in a large fiscal stimulus program). As to inflation, what we can infer from the market’s movement is that it may be around the corner, as we see in the following chart illustrating the inflation expectations in the five years beginning five years from now, which are embedded in TIPS pricing.
How will housing be impacted?
So far, we’ve simply recapped what the market already knows. Now let’s go a step further, the one venturing into the lesser explored path of how an accelerator can also be a brake. Let’s start with interest rates. As we noted, the 10-year Treasury yield rose by roughly 45 basis points or so in the past week, and that is the benchmark for many conventional mortgage loans and some corporate bonds.
