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Republican Tax Cuts Expected to fuel faster Inflation, drive T-Bond yields sharply higher

Dec 20, 2017

     Ever since the election of Donald Trump as President, on Nov 8th, 2016; traders have bid-up the combined values of the US-stock market indexes by roughly +$5.7-trillion, the biggest gain in such as short period in time, in the history of Wall Street. Bullish traders have become fabulously wealthy, as they correctly bet that the slim Republican majority on Capitol Hill, would be able to muscle through the largest tax overhaul in 30-years. The Bulls were undeterred during months of false starts and a special counsel probe, during Trump’s first year in office.

     “Just what the country needs to get growing again,” said Senate Majority Leader Mitch McConnell, R-Ky, as he closed in on a $1.5 trillion package that would give generous tax cuts to corporations and the wealthiest Americans — Trump and 14 Republican Senators among them — and more modest tax cuts to low- and middle-income families. McConnell shrugged off polls finding scant public enthusiasm for the measure, saying the legislation would prove its worth. “Big bills are rarely popular,” he said. The Republican party views passage of the tax cuts as crucial to retaining its House and Senate majorities in next year’s elections.

     Not surprisingly, Senate Minority Leader Chuck Schumer (D-NY) said Republicans would “rue the day they passed this bill.” “This tax bill will be an anchor around the ankles of every Republican. If they haven’t learned it yet, they will learn it next November. Republicans will rue the day they passed this bill and Americans will never let them forget it.” He added, “What has been sold as a job creator and wage booster will, of course, do little of either as companies are already initiating stock buybacks worth hundreds of millions of dollars instead of hiring more workers and raising wages. Ultimately, Republicans have taken what they called a once-in-a-generation opportunity on tax reform and squandered it on corporate welfare and tax cuts for the rich.”

      The Joint Taxation panel says the tax cuts would widen the US’s federal shortfalls by $1 trillion over a decade, even when factoring in economic growth that lower taxes would stimulate. It’s an unusual example of deficit spending with tax cuts at a time when the economy is already expanding at more than +3%.

     It would cut the corporate income tax rate to 21% from 35%, and would create a 20% business income tax deduction for owners of “pass-through” businesses, such as partnerships and sole proprietorships; and allow for the immediate write-off by corporations of new equipment costs; and eliminate the corporate alternative minimum tax.

     Under a new territorial system, the bill would exempt US multi-national corporations from taxes on most of their future foreign profits. It also sets a one-time tax for companies to repatriate more than $2.6-trillion now held overseas, at rates of 15.5% for cash and cash-equivalents and 8% for illiquid assets.

     According to the Joint Committee on Taxation, this proposal would allow Multi-national companies to collectively pay just $298-billion in taxes on their offshore earnings, rather than the roughly $752-billion that they owe, meaning that this proposal would give US-multinationals a tax break of $454-billion.The companies that would benefit most from this low-rate deemed repatriation are precisely those companies that have been the most aggressive in their use of offshore tax avoidance schemes. The biggest beneficiary of the deemed repatriation proposal would be Apple, <AAPL>, the company now most notorious for its international tax avoidance. 

     Once passed by Congress, the changes would be in effect for 2018 taxes, with tax returns for 2017 unaffected. JP-Morgan chief Jamie Dimon is a big proponent of corporate tax reform. “Some companies will raise wages. Some will buy other companies. Some may increase dividends and buybacks. Don’t act like that is a bad thing. That is their money. Think of it as a QE-4. That money gets recirculated in the American system.” After the bill passes “probably a trillion dollars will come back from overseas,” he added. “Cumulatively over time that will accelerate growth in the American economy.” Once the plan is signed into law, workers could start seeing changes in the amount of taxes withheld from their paychecks early next year, lawmakers said — though taxpayers won’t file their 2018 returns until the following year.

     As such, a bond market bubble is the biggest threat to the US-economy right now, warns former Federal Reserve chief Alan Greenspan. “By any measure, real long-term interest rates are much too low and therefore unsustainable. When they move higher they are likely to move reasonably fast. We are experiencing a bubble, not in stock prices but in bond prices. This is not discounted in the marketplace.” When central banks start withdrawing liquidity from the financial system in earnest by selling their bond holdings, Greenspan believes that long term interest rates will spring sharply upwards. Thus, bond prices will collapse. Greenspan says that would lead to the worst bout of stagflation since the 1970’s, a period when inflation accelerated amid a stagnating US-economy.

     Indeed, Global bond yields snapped higher on Dec 18-19th, -in one of the biggest two-day increases of the year, as Congress moved to turn the tax bill into law. The sweeping package would add at least $150-billion per year to the US’s budget deficit and fuel a faster rate of economic growth, both factors that could drive inflation and interest rates higher. The yield on the benchmark 10-year Treasury note jumped +15-bps to 2.47%, while the yield on the 30-year Treasury bond was also up +14-bps at 2.825%. That steepened the 10-year and 30-year part of the yield curve.

     Bullish analysts on Wall Street generally believes that under the guidance of the next Fed chief, Jay Powell, borrowing costs will stay low in 2018. For that reason, markets are generally unprepared for a possible surge in US-interest rates that could occur. The big surprise could be sharply higher 10-year Treasury yields, and that’s something that investors are not really positioned for.

     Three catalysts could drive the 10-year yield higher. First, economies all around the world accelerating. Secondly, the tax package will fuel a faster rate of growth. Third, is the potential for inflationary pressures to increase as labor markets get tighter and tighter. The rate of unemployment has already dropped to 4.1% and as the economy picks up speed, employers may have to pay higher wages to attract increasingly scarce talent. The net result of all that could be an acceleration of growth, and in turn, an acceleration of inflation which pushes the 10-year and 30-year Treasury yields sharply higher.

     Right now, traders in the fed funds futures markets are only anticipating two quarter-point Fed rate hikes by the middle of 2019, to a mid-point of 1.875%,  even the Fed is projecting 4 rate hikes to 2.375% by then. There is great skepticism about the independence of the next Fed chief Jay Powell, who is a lawyer by trade, and is a novice about the psychology of the financial markets. Powell is expected to be under the control of the Trump Treasury and the president’s economic adviser, Gary Cohn, the covert #2 man from Goldman Sachs. Mr Powell could even be more dovish that Fed chief Janet Yellen, whose ultra-easy money policies helped to massively inflate the fortunes of the ultra-wealthy invested in the US-stock markets. 

     However, the Republican plan to stimulate the economy with tax cuts is going to put the Fed in a bit of a box because this fiscal stimulus with a 4% unemployment rate heading into the ninth year of an expansion, might cause the long dormant, Bond market Vigilantes to reawaken, and jolt longer-term bond yields higher- and more than otherwise . For investors in the US T-bond and corporate bond markets, the Republicans’ tax cuts probably signals the beginning of a Bear market. 

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