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The Deficit and the Stock Market

A shrinking budget shortfall could boost stocks, regardless of any Federal Reserve action.

We’ve been writing a lot lately in these weekly Mind Over Markets columns about the ramifications of the massive monetary easing by the Fed and so many other central banks.

That’s because this column generally covers the investment world from a macroeconomic, “big picture” perspective. This approach has been particularly relevant over the last five years or so, since the emergence of the 2008 financial crisis and ensuing recession.

Corporate earnings, dividend increases and share buybacks by corporate America have played a big role in powering the US stock indices to new all-time highs. However, the common perception, correct or not, is that easy monetary policy has been the primary reason for the advance.

Macroeconomics and the impact of the Fed are in full focus again this week, as the US stock market continues to climb. One of the catalysts was comments on Tuesday by David Tepper, a leading hedge fund manager.

A concern among investors (and a hope among those awaiting a market pullback) is when the Fed will cut back on its bond-buying program. The consensus view is that any tapering of Fed bond purchases would lead to a drop in the markets.

Tepper, who runs Appaloosa Management, contended that concerns about a possible reduction of the Fed’s bond-purchase program are overblown. The Fed currently is buying $85 billion per month of government bonds and mortgage securities.

Tepper said investors shouldn’t worry about less Fed buying. In fact, he hopes the Fed starts trimming its purchases sooner rather than later.

His out-of-the-box reasoning: If the Fed doesn’t start tapering its asset purchases, we could see a market melt-up that could end badly.

This is because the US federal budget deficit is set to shrink dramatically in the next six months, so the Fed would be injecting more money into the economy than the federal government will need to borrow. These additional funds have to go somewhere.

Stocks and the real economy are the two likeliest destinations. Tepper would rather see a steady, gradual advance than a blow-off rally. So his reasoning is that less would be more as far as the Fed is concerned.

The Federal Reserve says it already has a plan for winding down its bond-buying program. This involves reducing the amount of bonds the Fed buys slowly and gradually, varying purchases depending on the job market and inflation.

The timing on when to start is still being debated. Fed officials say they’re focusing on clarifying and communicating the strategy so that the financial markets don’t overreact when the time comes.

From Wild Turkey to Cold Turkey

Richard Fisher, president of the Federal Reserve Bank of Dallas, put it colorfully and succinctly: “I don’t want to go from wild turkey to cold turkey.”

Additional news on the reduced size of the federal budget deficit came on Wednesday, when the nonpartisan Congressional Budget Office slashed its projection for the current fiscal year, which ends on Sept. 30.

In one of its periodic updates, the CBO now estimates that the deficit will be $642 billion, or 4 percent of the nation’s gross domestic product (GDP). The main reasons: bigger-than-expected tax receipts and payments to the federal government from Fannie Mae and Freddie Mac.

Keep in mind, the Fed currently is buying $85 billion of securities per month, or $1.02 trillion per year. Theoretically, that’s $378 billion more than necessary.

Just three months ago, the CBO projected a current-year deficit of $845 billion, or 5.3 percent of GDP. The US budget deficit peaked at 10.1 percent of GDP in 2009, according to the CBO. In 2012, it was 7 percent of GDP.

Some observers warn that the deficit improvement stems partly from many upper-income taxpayers choosing to pay taxes at 2012 rates before they increased this year.

In addition, though, government spending supposedly is falling, down by 2 percent in the first seven months of the fiscal year, even before adjusting for inflation. Military spending, unemployment benefits and other discretionary spending have all declined, and the $85 billion of across-the-board sequester cuts have only just begun.

The CBO also projected a deficit of $560 billion, or 3.4 percent of GDP, for fiscal 2014; and a deficit of $378 billion, or 2.1 percent of GDP, in 2015.

But the agency said deficits would start rising again in 2016 as spending levels increase, especially for entitlement programs like Medicare and Social Security in the 2020s as more people reach retirement age.

Since 2008, many investment professionals and commentators have been predicting that the Fed’s money-injection policies inevitably would lead to high inflation and skyrocketing interest rates.

So far, they’ve all have been wrong. The reason is quite simple: Much of that newly printed money hasn’t yet found its way into the real economy because of slack loan demand and/or tight lending standards.

Indeed, the consumer-price index fell 0.4 percent in April, the US Labor Dept. said yesterday, the second consecutive monthly decline. Over the last 12 months, inflation has climbed just 1.1 percent. Without energy and food, so-called core consumer prices rose 0.1 percent in April, the same as in March.

The near-term improvement on the deficit front gives our political “leaders” in Washington DC more time to develop a plan to deal with the whole budget situation as the government approaches yet again its legal limit for borrowing more money.

But that’s both good news and bad news. Pushing back the deadline removes what little sense of urgency existed in the first place.

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