Bad, not bearish

From a markets perspective, the main issue with US fiscal policy now is that the spending side of it is stimulating aggregate demand growth and thereby provoking a reaction from the Fed. It is not the only consideration driving the Fed, but fiscal policy’s current relevance to markets arises primarily through that channel.

The steeply rising trend in the federal debt/GDP ratio is an entirely separate issue and the subject of this report. For now, the debt itself is not a problem for markets, because a negative (default free) “interest-growth differential” is supporting very high fiscal capacity here.

Of course, the flip side of this is that fiscal capacity would fall if the bond yields were to rise above the economy’s growth rate or – more precisely – if investors changed their perceptions to view that as the long-term equilibrium condition.

This sensitivity actually fits my view – developed for other reasons – that in the current environment the equity market should be more-than-typically sensitive to changes of long-term bond yields.  Having said that, though, this link is mostly coincidental. Fiscal concerns are not the main channel linking equities to the perceived trend in the default-free component of the long-term Treasury yield.

Closely related, our focus should probably remain on the drivers of the default-free component of the long-term Treasury yield, which is basically all of it for now.  In other words, watch the economy and the Fed, not the debt/GDP ratio. Then again, you already knew this.  Maybe the point of this note is more to help you understand how you knew.