The shock and awe of the first few Trump weeks continues. Market volatility has increased a bit without much direction. Long-term bond yields have dipped slightly as investors are hopeful that DOGE efforts to reduced Federal spending will help to narrow deficits and relieve upward pressure on rates. As for actual data, what we have gotten over the past few weeks and will get this coming week reflects actions of the prior administration. Yet it sets the table for what may lie ahead.
Let’s start with the labor market. January’s increase of 143,000 jobs was modest. However, the unemployment rate fell to 4.0% and revisions of 2024 data suggest that about half a million fewer jobs were created than previously reported. Bottom line: the labor market remains tight. While there are no signs that wage pressures are rising, a tight market suggests the Fed should take its time before lowering the Fed Funds rate further. At the most recent FOMC meeting, rates were unchanged as expected. Last week’s data suggests the Fed will remain on hold at least into late spring, barring sudden economic weakness. One jarring report last week was the University of Michigan survey of consumer confidence. Embedded in that report was a 100-basis point increase in consumer inflation expectations over the previous month, undoubtedly related to fears related to the possible implementation of broad tariffs. Today’s announcement of steel and aluminum tariffs with more promised to come won’t change that psychology quickly.
What consumers perceive matters. It reflects how and when they spend. Trump backed off of tariffs against Canada and Mexico for 30 days. That calmed the waters a bit. Today’s announcement may sound dire to some but equity futures are up this morning suggesting the investor class is taking the announcement in stride. The survey, however, remains a warning that tariffs are not likely to be very popular to the overall public. Even Trump has only so much political capital.
This week will be a week full of economic data. Fed Chair Jerome Powell will testify before Congress for two days. His comments are likely to mirror his post-FOMC conference call. However, he is likely to be entering the lion’s den. Trump wants to see rates cut sooner than later and Republicans in both the House and Senate will do his bidding. Powell will likely escape unscathed, but once again the optics could create some volatility. Coincident with his comments, we will see reports on January consumer and producer prices. Expectations are for numbers consistent with January with inflation continuing to hover around 3%. Any deviation will be reflected immediately in the bond market first. Friday will see a report on January retail sales. They have generally been strong since the Election. Hopefully, that continued into January.
For all of us, trying to sift through all the Executive orders, tweets, etc. is difficult. It seems not an hour goes by without some new directive. What makes analyzing the information more difficult is that much of the data and news is delivered in exaggerations and interpreted differently depending largely on one’s viewpoint. Facts are intertwined with misinformation.
Today, our federal government spends just shy of $7 trillion while taking in close to $5 trillion in revenues, leaving a deficit that approaches $2 trillion. Without significant changes, $2 trillion annual deficits are likely to continue. U.S. GDP is a bit under $29 trillion. Thus, a $2 trillion deficit is 7% of GDP.
Our nation’s debt outstanding now exceeds $36 trillion. Annual interest payments on the debt now exceed $1 trillion, more than the nation spends on defense and more than it spends on all other discretionary items. But does the size of our debt or deficits really matter?
Let me try to put that in some perspective. Virtually all of us have credit cards. They have limits on how high our outstanding balances can go. What happens when you reach that limit? You can’t borrow. The U.S. has a presumptive debt ceiling and every time that limit is approach, Congress argues. But it always raises the limit because, given that we will be in a deficit situation for the foreseeable future, the only alternative to raising the debt ceiling to is stop paying bills like Social Security, etc., or default. That isn’t going to happen. So, let’s look at another analogy. You run a business. You have a balance sheet with both equity and debt. You might have a credit line that helps with seasonal increases and decreases in monetary needs. But, like with credit cards, your borrowing capacity isn’t infinity. As you build up the size of your draws against your credit line, you face the risk that your line will be frozen or revoked. You can sell long-term debt but as your balance sheet weakens, what you have to pay in interest goes up. Eventually, that avenue comes to a dead end as well.
While debt is building, business goes on. No alarm bells ring. But when they do, disaster lurks. Companies go broke when they have no cash left, when suppliers won’t let you buy on credit, when your banks say sorry.
Back to the Federal government. I don’t know where the crisis point is. No one does. But there is a limit and we don’t want to encounter it. When you need to borrow 7% of GDP just to stay even, you run the risk of running out of lenders willing to buy your debt. For many decades astute economists and business icons like Warren Buffet have suggested that domestic sources can comfortably support a deficit of 3% of GDP. The difference between 3% and 7%, is four percentage points. 4% of $29 trillion is a bit over $1 trillion. What all these numbers imply is that a “safe” deficit today is about $1 trillion.
Getting from $2 trillion to $1 trillion sounds Herculean. But is it? In 2019, the last year before Covid, the deficit was $984 billion. Even in 2022 it was $1.38 trillion.
To keep debt and debt service within manageable limits, it’s important to reduce the deficit rapidly. Decreasing it by $100 billion a year might seem directionally positive but adding $1.5 trillion or more to our debt burden each of the next four years wouldn’t be a very smart approach, especially if foreign buyers stop buying Treasuries.
Enter Trump, DOGE, and Elon Musk. So far, for all the antics and Executive Orders, the actual cuts have been very modest. The brouhaha surrounding USAID makes points about some frivolous spending as well as tactics used to make spending cuts. But even eliminating everything USAID spends is a drop in the bucket, a distraction from the real task. If DOGE is a serious endeavor, it will have to go at the meat of the problem. Where is that? There are obvious pockets with huge savings potential. Medicare/Medicaid fraud is one. Here the focus should be on how payments are made, how procedures are authorized, and who is an authorized payee. Even the most liberal states in the U.S. don’t have single payor health care systems because they simply don’t have the framework to execute the business properly. The “cost” of single payer health care, assuming it mimics Federal programs, is too huge for even New York or California to bear. The system needs fixing. The next place to look is defense. War tomorrow is going to be different than wars past. A large percentage of procurement projects are cost-plus, eliminating all incentives to keep expenses down. As a sidebar, major cuts in defense would hurt Musk as well. Fewer trips to the Space Station or delays in lunar or Mars programs will hurt. These have to be scrutinized along with everything else.
Getting to $1 trillion will be hard. Every dime not spent is one less dime going into someone’s pocket. Any person or company that loses funding will scream. Trump, Musk and the DOGE team are pushing the limits of what they can do. There will be many court challenges and they will lose their share. Cutting the Federal bureaucracy isn’t as easy as making broad cuts in the business world.
The movement to get the data necessary to make the decisions where to cut ruffles feathers, and courts will have to intercede to provide the necessary guard rails. But it will be very difficult to determine what can be cut if you don’t understand how the money is spent.
Getting deficits down isn’t just about taking a hatchet to expenses. If one shrinks the size of government that means the asset base can be shrunk. That means lease terminations. Buildings that can be sold. The government can extract royalties for oil drilling leases, or spectrum sales. How many post offices can be sold without materially impacting postal service? Everything has to be examined within the constraints of exiting labor agreements, outstanding contractual commitments, and service needs. This is not going to be an easy task. Trump and Musk’s tactics will make it hard for many to swallow. But the kinder gentler approach won’t work if it can’t meaningfully cut the size of deficits.
The good news is that the Administration starts from strength. We are in a solid growing economy with minimal unemployment. If actions to rein in government spending subtract a percentage point from growth and create a modest bump in the unemployment rate, the long-term benefits will outweigh the short-term pain.
I have said multiple times that if I had to watch one economic number, it would be the 10-year bond yield. Trump and Musk don’t set long-term bond rates. The market does. Treasury can game this a bit by borrowing ever more short-term and not issue many new 10-year bonds. But Treasury Secretary Bessent has argued against that approach. The near-term schedule which was announced last week suggesting borrowing will remain skewed to the short-term, was largely developed before Bessent took office. The next schedule due in the spring will be more telling. Tariffs are inflationary. The survey last week that said consumers are fearful, raised eyebrows. Yet the 10-year yield over the past few weeks has crept lower. Bondholders are showing approval despite all the rancor and chaos. So, turn off MSNBC and Fox News. Read the bond market’s tea leaves instead.
We are past the halfway point of earnings season. So far it has been on par with the mean of the last several years. 77% of reporting companies have beaten analyst estimates, right in line with historic trends. The size of the surprises was also in line, about 7.5%. Equity prices are a function of earnings and interest rates. If earnings continue to grow 8-12% and bond yields can remain steady, it should be another positive year for equities. No doubt getting there will be chaotic, especially over the next few months. The path to earnings growth will be laid more by the Fed than the White House. The path for the 10-year bond yield will reflect the success (or failure) of DOGE combined with the impacts of tariffs and tax policy. Stay tuned.
Today, Mark Spitz is 75. Roberta Flack is 88. Robert Wagner turns 95.
James M. Meyer, CFA 610-260-2220