Tax-Reform Opponents Blast Treasury Report As "Nothing More Than One Page Of Fake Math"

Yesterday, we highlighted a one-page report prepared by the Treasury Department which claimed that – in what was perhaps one of the most unrealistically optimistic budget projections to ever be produced by the US government agency - the Senate’s version of the Republican tax plan would, somehow, bolster GDP to a 2.9% real growth rate over 10 years.

The report – a transparent attempt to distract from the plan’s elimination of more than $1.5 trillion in total receipts, while emphasizing its potential pro-growth aspects – relies on a scenario where the economy achieves a baseline of 2.9% GDP growth over the coming decade, compared with the Treasury’s previous projection of 2.2%.

This additional 0.7 percentage point of annual growth, the report claims, will lead to an increase in tax revenue of $1.8 trillion. Treasury "expects approximately half of this 0.7% increase in growth to come from changes to corporate taxation, while the other half is expected to come from changes to pass-through taxation and individual tax reform, as well as from a combination of regulatory reform, infrastructure development, and welfare reform as proposed in the Administration’s Fiscal Year 2018 budget."

To transform these projections into a reality, the US economy would need to achieve the longest cycle of uninterrupted growth in US history.

Unsurprisingly, the report has elicited howls of outrage from Democratic lawmakers and academics, who blasted Treasury Secretary Steven Mnuchin – a former Goldmanite – for the obviously bogus report, as Reuters reported.

Even Mnuchin’s fellow Republicans joined in the outrage pow-wow: Case in point, the Committee for a Responsible Federal Budget, a conservative fiscal watchdog in Washington, claimed the report, which was prepared by Treasury’s Office of Tax Policy, “makes a mockery of dynamic scoring and analysis."

Meanwhile, Senate Minority leader Chuck Schumer said the Treasury analysis was “nothing more than one page of fake math."

Of course, when the next recession hits – which, if the past is any guide, should happen before the end of 2019 - the yield curve will be steeply negative, crushing the financial sector. Government tax revenues will plunge and government-borrowing will soar. In a scramble to monetize the explosion of debt before it snowballs into one of the most severe debt crises in modern history, the Fed will launch QE4 at a time when interest rates are still low by historical standards and the central bank’s swollen, post-crisis balance sheet may not yet be fully unwound.

In what was perhaps the report"s most entertaining paragraph, Mnuchin & Co. engage in what could be construed as a little light-hearted trolling of the economic community.

We acknowledge that some economists predict different growth rates. OTP projects that at approximately 0.35% of incremental annual GDP growth, Treasury tax receipts would generate approximately $1 trillion of incremental revenue. Neither JCT nor Treasury has released a score showing increased tax receipts from the House plan, though we would not expect the results to be materially different.

As Reuters points out, the Wharton Business School at the University of Pennsylvania also issued a report on Monday, which found that the plan approved by the full Senate would add $1.5 trillion to the national debt over 10 years, “even with assumptions favorable to economic growth."

One week ago, in its latest assessment of the current state of tax reform in the aftermath of the Senate"s passage of the tax bill, Goldman analysts calculated that, while the growth impact from tax reform would increase fractionally to around 0.3% in 2018 and 2019 "reflecting the slightly larger amount of tax cuts in the Senate plan following revisions, and our expectations regarding the eventual compromise", there would be a very modest - if any - boost to US economic growth from tax reform.

Notably, the sparring over economic forecasts came as Republicans resumed efforts to reconcile two tax-overhaul bills, one approved by the Senate and one by the House of Representatives.

Regardless of whether its projections are based on sound numbers, Republicans probably won’t hesitate to use it as a cudgel to beat back deficit hawks who are threatening to delay the tax plan by demanding that Republicans rein in cuts to stop the plan from blowing out the deficit and piling on the debt.

The Scariest Forecast For Treasury Bulls

With Trump"s border tax adjustment looking increasingly likely, the stock market - as JPM has warned in recent days - is starting to fade the relentless Trumponomic, hope-driven rally since election day instead focusing on the details inside the president-elect"s proposed plans. And, as explained earlier in the week, if the border tax proposal is implemented, economists at Deutsche Bank estimate the tax could send inflation far above the Federal Reserve"s 2% target and drive a 15% surge in the dollar.

While this would be bad for stocks, as a 5% increase in the dollar translates into about a 3% negative earnings revision for the S&P 500 all else equal, a surge in inflation would also wreak havoc on bond prices, and send interest rates surging, at least initially, before they subsquently plunge as a result of a rapidly tightening, deep "behind the curve" Fed unleashes a curve inversion and recessionary stagflation becomes the bogeyman du jour.

There"s more.

In a separate report by Deutsche, the bank looks at future prospects for rates and concludes that "tightening monetary policy, higher breakevens, and declining central bank purchases relative to net supply should all contribute to significant bearish steepening during 2017."

In its analysis of future bond rates, Deutsche Bank says that the biggest risk is that when looking at the menu of "threats" presented by the Trump stimulus, "there is a significant risk that if the Fed decides to aggressively lean against higher inflation expectations, the entire “regime shift” might stall. That is, higher wages and inflation expectations are a prerequisite to the substitution of capital for labor, which is in itself necessary for more rapid productivity growth and hence higher potential growth and sustainably higher levels of r*."

And then the focus shifts so that whatever degree of accommodation is warranted, there will be the push to rebalance away from rising short rates to shrinking the Fed’s balance sheet, in other words, the Fed begins real normalization.

In DB"s model, the net effect of ending reinvestment of SOMA portfolio run-off, some asset sales, and an ECB taper is almost 200 bps. This would allows 10s to move well over 4 percent in 2018. That although roll offs are significant - maybe $50 billion/month – in order to get the balance sheet down from more than $4 trillion to say $1 trillion before the 4-year presidential term is over would still require asset sales of  approximately $50 billion.

Assuming Deutsche Bank is correct, the result would be the scariest forecast bond bulls have seen in years: a 10-Year TSY whose yield fades all gains attained during the past decade, in the span of just two short years, hitting 4.5% in early 2019. The adverse implications from such a fast, steep move on all asset classes, not just bonds, would be devastating.

Will this forecast come true? Readers can make their own determinations upon reading DB"s assumptions:

Formally, DB"s model of 10s has three explanatory variables. The main driver is the ratio global QE purchases to net supply in nominal terms with a nine-month lead, i.e., the market is forward looking. Global QE and supply figures are from the US, Europe and Japan. The other two variables in the model are Fed funds and the 2s/funds spread. The model is estimated between October 2006 and September 2016.

These assumptions are summarized in the following three scenarios:

1. Base case: Trump’s fiscal stimulus, amounting to about $530 billion per year for ten years.


2. Base case + ECB taper + Fed portfolio rolloff. In this case, 10s are about +70bp higher in yields than in the base case.


3. Base case + ECB taper + Fed portfolio rolloff + Fed asset sales. 10s are about +100bp higher in yields than in base case.

The assumptions in the scenarios are:

• President-elect Trump’s stimulus package, scored by the Committee for a Responsible Federal Budget adds $5.3 trillion to the deficit over the next decade. This averages to $530 billion per year, starting in July 2017, around the time the plan is expected to be passed by Congress.


• The ECB tapers QE purchases by ½ in 2018, and stops all purchases in 2019.


• Fed balance sheet reductions: The Fed stops reinvestments of maturing Treasuries and MBS pre-payments starting Q4 2017. Asset sales at $250 billion in 2018 and $500 billion in 2019.


• The Fed funds target range rises to 2.50%-2.75% by year end 2019, with the 2s/funds spread at 60bp.

Visually:

Needless to say, DB is convinced that there is a lot of pain coming for the bond market. To wit:

"Our strongest market view, therefore, is that investors should be short duration. Rates are going higher. The curve should end up steeper but this Fed"s initial reaction as per this week can confuse curve dynamics. Real rates should not rise more than breakevens. In the short run dollar strength should persist."

We are far less confident, especially if indeed the border tax is implemented, sending the dollar soaring, US exports, and GDP crashing, and corporate profits plunge. In short: if Trump unleashes a recession by implementing a policy which is meant to eliminate the US trade deficit.

In such a case, forget steepeners: buy every flattener you can get your hands on, and then use leverage, because before you know it the 2s30s will be back in the double digits, then single, and then, not too long from now, negative.

Whether that is the catalyst that will kick off QE4 or whatever the current number is, we don"t know, but by that point China will be spitting up blood as a result of a historic collapse in the Yuan, hundreds of billions in monthly outflows and a paralyzed, and crushed financial system. Ironically, in light of the devastation that may soon befall China should Trump"s policies pan out, the US - recession or not - may still be the "cleanest dirty shirt" in a world where things are about to get very messy.