After months of droning impeachment hearings against
, a more typical type of wrangling is heating up in the nation's capital -- squabbling over money.
But this year,
, especially its veteran membership, is being treated to surprises with regard to hashing out the coming year's budget. The government is running an operating surplus -- that is, it's actually making money. The economy is strong, and the volume of outstanding Treasury securities has dropped to near-1995 levels. The
Congressional Budget Office
projects a total of $4 trillion in surpluses over the next 15 years.
Against this backdrop, Republicans are once again proposing a tax cut, while Democrats are proposing major spending increases. The $1.77 trillion proposal Clinton unveiled yesterday includes massive increases in spending as well as a radical plan to keep Social Security and Medicare funded further into the next century.
But the vast differences in these proposals can guarantee only one thing -- gridlock. That's good for the bond market; during gridlock, the national debt will continue to be repaid.
"At a minimum, the Republicans and Democrats have agreed to use 60% to 62%
of the surplus for Social Security. But if nothing happens at all, the surplus goes to paying down Treasuries," says Steve Van Order, market strategist at the
. "The odds of that are pretty reasonable."
'The bond market would only get spooked if we really felt we were moving toward a bill that had massive tax cuts that ripped into the surplus, lifted caps on discretionary spending and had new benefit creations that assumed spending cuts down the road,' says Prudential's Chuck Gabriel. 'At this point I wouldn't bet on any of it.'
Clinton, emboldened by the prospect of operating surpluses over the next 10 to 15 years, has proposed shoring up the Social Security program by investing payroll taxes, expected surpluses and cigarette taxes. He's also proposed setting aside $2.2 trillion of the projected $4 trillion surplus to pay down the national debt.
"He's quietly created the pretense to slip the caps from the 1997 budget deal," says Chuck Gabriel, political analyst at
. "Republicans are looking at a 10% tax cut. These are two radically different positions; they're perfect prescriptions for gridlock."
While paying down the national debt is good for the bond market and consumers, until now the president hasn't embraced this as a policy issue so much as it has happened by accident. Due to economic strength, higher-than-expected tax receipts and cuts in federal spending -- exemplified by 1997's balanced-budget agreement -- the amount of outstanding Treasury securities has declined steadily over the last three years. In 1996, $3.5 billion in Treasury bonds were outstanding, making up 30.8% of a total $11.2 billion in debt securities, according to the
Bond Market Association
. This year it's $3.3 billion of $12.8 billion, or 26%.
As debt is paid down, the yield on Treasury bonds has continued to decrease. Since the third quarter of 1995, when the 30-year bond was yielding 6.6%, the bond yield has decreased about 150 basis points. The strength in the economy, low inflation and problems in foreign countries are more responsible on a day-to-day basis for this rally, but the decreased supply has a more subtle long-term effect on the bond market.
Since Treasury securities are a smaller percentage of the entire bond market than they used to be, bond indexes reflect a similar makeup, spurring more purchases of higher-risk securities by portfolio managers. And as yields decrease on Treasury bonds, yields on corporates drop as well. Even if a company pays 3% more than the average Treasury bond to issue debt, five years ago that would have cost 11% annually -- now it's more like 8%.
"Ultimately, it supports high-quality spread paper," says Van Order. "Index funds would have a tendency to hold fewer Treasuries. It's a subtle effect that goes into the stew, vs. something that turns around in a day."
The entire yield curve, with the exception of the 30-year bond, is yielding less than the 4.75% federal funds short-term lending rate, usually evidence that the market is expecting a rate cut from the
Federal Open Market Committee
. Certainly there are other factors for this rally -- for example, the unattractiveness of emerging markets -- but the lack of supply is reportedly forcing yields lower.
The low bond yields have "become somewhat chronic of late in the face of little hope for a rate cut," says Tony Crescenzi, chief bond market strategist at
Miller Tabak Hirsch
. "And it may be because of the supply-demand situation."
Goodbye Spending Caps?
But what's potentially troubling for the bond market within Clinton's proposal is the undoing of caps placed on discretionary spending in the 1997 budget agreement. The discretionary-spending cap for this coming year is $571 billion, but that might come undone if the proposed increases in defense spending do not result in spending cuts elsewhere. Clinton's proposal also assumes that the CBO-projected surpluses will actually come to pass, even as
said last week in testimony that "projections are just that -- projections."
Greenspan half-heartedly endorsed Clinton's basic proposal to shore up Social Security within the confines of the operating budget last week during his
House Ways and Means Committee
testimony. While fiercely opposed to investing the funds in the stock market, as the president has suggested, Greenspan recognizes that since the proposal treats the paying down of the national debt as second priority, he probably can't get a better deal out of it.
, meanwhile, supports paying down the debt. In
testimony today, he said the president's proposal would decrease the percentage of the budget devoted to debt service to 2% in 2014 from a 1993 estimate of 27% for that year.
The financial markets understand that the president's proposal is a political accomplishment. Given the Republican opposition to more spending and the president's aversion to cutting taxes without attempting to shore up popular entitlement programs, a status quo effort down the line seems likely.
"The bond market would only get spooked if we really felt we were moving toward a bill that had massive tax cuts that ripped into the surplus, lifted caps on discretionary spending and had new benefit creations that assumed spending cuts down the road," Prudential's Gabriel says. "At this point I wouldn't bet on any of it."