Managing Fiscal Policy Uncertainty Under Trump 2.0

Summary

Thoughts on the Market: Managing Fiscal Policy Uncertainty Under Trump 2.0

Published on January 30, 2025 by Morgan Stanley

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Introduction

In the January 30, 2025 episode of Thoughts on the Market, Morgan Stanley's experts delve into the intricacies of managing fiscal policy uncertainty under the re-elected Trump administration. Hosted by Michael Zesas, Morgan Stanley's Global Head of Fixed Income and Public Policy Research, alongside Matthew Hornbach, Global Head of MacroStrategy, the discussion provides a comprehensive analysis of the current fiscal landscape, recent Federal Open Market Committee (FOMC) outcomes, and the implications for U.S. Treasury yields.

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1. Overview of the Episode's Main Topics

The episode centers on two pivotal themes:

• US Fiscal Policy Expectations: An exploration of the fiscal strategies and priorities under President Trump's second term, particularly focusing on tax policies and deficit implications.

• U.S. Treasury Yields Trajectory: Analyzing the factors influencing the recent surge in Treasury yields and forecasting their future path amidst fiscal uncertainties.

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2. Insights from the Recent FOMC Meeting

Michael Zesas opens the discussion by highlighting the significance of fiscal policy as a major market influencer. He prompts Matthew Hornbach to share his insights on the latest FOMC meeting.

Matthew Hornbach notes, “Investors came into the FOMC meeting this week with the view that they were going to hear a message from Chair Powell that sounded very similar to the message they heard from him in December” (00:35). The outcome, according to Hornbach, affirmed investors’ expectations that the Federal Reserve would not lower interest rates in the upcoming March meeting, emphasizing a data-dependent approach.

An unnamed speaker adds, “The Fed, as ever, remains data dependent” (01:27), underscoring the centrality of economic data in shaping Fed policies.

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3. US Fiscal Policy Under Trump's Second Term

Michael Zesas shifts focus to the fiscal policies anticipated under President Trump’s renewed administration. He outlines the government's budget baseline and the president's fiscal priorities.

Zesas explains, “The real big variable here is the set of tax cuts that expire at the end of 2025” (02:04). These tax cuts, established during Trump's first term, are pivotal in determining the future deficit trajectory. If allowed to lapse, the deficit is projected to decrease by approximately $100 billion next year. Conversely, extending these cuts, possibly alongside additional measures like lifting the cap on state and local tax deductions or introducing a domestic manufacturing tax credit, could expand the deficit by a couple of hundred billion dollars (02:04).

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4. Impact of Fiscal Policy on Treasury Yields

The conversation naturally transitions to the recent spike in U.S. Treasury yields. With 10-year yields nearing peaks not seen since before the global financial crisis and rising by about a full percentage point since September, the discussion seeks to unravel the causes.

Hornbach attributes the yield surge to multiple factors, including persistent concerns over the growing deficit and increased government bond supply. He states, “Concerns around the deficit are definitely a factor and in particular, how those deficits create more government bond supply” (03:13). Additionally, market dynamics such as investor momentum and reactions to key events, like the Trump administration’s inaugural actions, have exacerbated the yield movements.

Zesas adds, “they saw yields moving higher and invested in that direction” (04:35), highlighting the role of investor behavior in the current Treasury market volatility.

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5. Legislative Process and Deficit Impact

Understanding the legislative pathway for fiscal policy is crucial. Zesas outlines the procedural steps required to extend tax cuts, especially given the slim Republican majorities in both the House and Senate.

He explains, “Extending these tax cuts in the way Republicans want to do it probably means they won't get enough Democratic votes to cross the aisle in the Senate to avoid a filibuster” (05:42). Consequently, budget reconciliation becomes the necessary route, allowing passage with a simple majority. The process involves determining acceptable deficit expansion levels, with key milestones expected by May and intensifying negotiations in the fall (05:42).

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6. Upcoming Key Dates and Their Significance

The panel emphasizes the importance of monitoring specific congressional deadlines and events that could influence fiscal policy outcomes and, by extension, Treasury yields.

Zesas points to the March 14 deadline for extending stopgap appropriations, noting, “there will likely be a lot of chatter amongst Congressional Republicans about fiscal expectations” (07:38). This period will be critical for gauging the administration's fiscal strategies and their market implications. Additionally, the fall negotiations on tax provisions and possible tariff adjustments remain pivotal factors that could sway deficit projections and Treasury market stability (07:38).

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7. Treasury Yields: Short-Term Volatility vs. Long-Term Trends

Hornbach assesses the potential volatility in Treasury yields driven by fiscal policy uncertainties. He asserts, “Any volatility in the negotiation process will almost certainly show up in treasury yields over time” (07:13). Despite this near-term uncertainty, there is a consensus that yields may trend lower towards the end of the year, contingent on eventual fiscal policy resolutions.

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8. Conclusions and Insights

The episode concludes with a consensus that managing fiscal policy uncertainty under the Trump administration will be pivotal for market stability. The interplay between legislative actions, deficit management, and investor behavior will continue to shape Treasury yields and broader market dynamics.

Michael Zesas wraps up the discussion by encouraging listeners to engage with the podcast, fostering a community of informed investors keen on market developments.

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Notable Quotes

• Matthew Hornbach (00:35): “Investors came into the FOMC meeting this week with the view that they were going to hear a message from Chair Powell that sounded very similar to the message they heard from him in December.”

• Unnamed Speaker (01:27): “The Fed, as ever, remains data dependent.”

• Michael Zesas (02:04): “The real big variable here is the set of tax cuts that expire at the end of 2025.”

• Matthew Hornbach (03:13): “Concerns around the deficit are definitely a factor and in particular, how those deficits create more government bond supply.”

• Matthew Hornbach (07:13): “Any volatility in the negotiation process will almost certainly show up in treasury yields over time.”

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Conclusion

This episode of Thoughts on the Market offers a thorough examination of the fiscal policy landscape under President Trump’s second term and its implications for U.S. Treasury yields. By dissecting legislative processes, deficit concerns, and market reactions, Michael Zesas and Matthew Hornbach provide valuable insights for investors navigating these uncertain times.

For those seeking to stay informed on market trends and fiscal policy developments, this episode serves as an essential resource, encapsulating expert analysis and forward-looking perspectives.

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Note: This summary omits non-content sections such as advertisements, intros, and outros to focus solely on the substantive discussions presented in the episode.

Transcript

[Michael Zesas]

Welcome to Thoughts on the Market. I'm Michael Zesas, Morgan Stanley's global head of fixed income and public policy research.

[Matthew Hornbach]

And I'm Matthew Hornbach, global head of MacroStrategy.

[Michael Zesas]

Today we'll talk about US fiscal policy expectations under the new Trump administration and the path for U.S. treasury yields. It's Thursday, January 30, at 10am in New York. Fiscal policy is one of the four key channels that have a major impact on markets. And I want to get into the outlook for the broader path for fiscal policy under the new administration. But, Matt, let's start with your initial take on this week's FOMC meeting.

[Unnamed Speaker]

So investors came into the FOMC meeting this week with the view that they were going to hear a message from Chair Powell that sounded very similar to the message they heard from him in December. And I think that was largely the outcome. In other words, investors got what they expected out of this FOMC meeting. What did it say about the chance the Fed would lower interest rates again as soon as the March FOMC meeting? I think in that respect, investors walked away with the message that the Fed's baseline view for the path of monetary policy probably did not include a reduction of the policy rate at the March FOMC meeting, but that there was a lot of data to take on board.

[Matthew Hornbach]

Between now and that meeting.

[Unnamed Speaker]

And, of course, the Fed, as ever, remains data dependent. All of that said, the year ahead for markets will rely on more than just Fed policy. Fiscal policy may feature just as prominently. But during the first week of Trump's presidency, we didn't get much signaling around.

[Matthew Hornbach]

The president's fiscal policy intentions.

[Unnamed Speaker]

There are plenty of key issues to discuss as we anticipate more details from the new administration. So, Mike, to set the scene here, what is the government's budget baseline at the start of Trump's second term, and what are the president's priorities in terms of fiscal policies?

[Michael Zesas]

You know, I think the real big variable here is the set of tax cuts that expire at the end of 2025. These were tax cuts originally passed in President Trump's first term. And if they're allowed to expire, then the budget baseline would show that the deficit would be about $100 billion smaller next year. If instead the tax cuts are extended, and if President Trump were able to get a couple more items on top of that, say, for example, lifting the cap on state and local tax deduction and creating a domestic manufacturing tax credit, two things that we think are well within the consensus of Republicans, even with their slim majority, then the deficit impact swings from a contraction to something like a couple hundred billion dollars of deficit expansion next year. There's meaningful variance there. And Matt, we've got 10 year treasury yields hovering near highs that we haven't seen since before the global financial crisis around 10 years ago. Yields are up around a full percentage point since September. What's going on here and to what extent is the debate on the deficit influential?

[Matthew Hornbach]

Well, I think we have to consider a couple of factors, the deficit certainly being one of them. But people, people have been discussing deficits for a long time now. It's certainly news to no one that the deficit has grown quite substantially over the past several years. And most investors expect that the deficit will continue to grow. So concerns around the deficit are definitely a factor and in particular, how those deficits create more government bond supply. The US treasury, of course, is in charge of determining exactly how much government bond supply ends up hitting the market marketplace. But it's important to note that the incoming U.S. treasury Secretary has been on the record as suggesting that lower deficits relative to the size of the economy are desired. Taking the deficit to GDP ratio from its current 7% to 3% over the next four years is desirable according to the incoming treasury secretary. So I think it is far from conclusive that deficits are only heading in one direction. They may very well stabilize and investors will eventually need to come to terms with that possibility. The other factor I think that's going on in the treasury market today relates to the calendar.

[Unnamed Speaker]

Effectively.

[Matthew Hornbach]

We have just gone through the end of the year. It's typically a time when investors pull back from active investment, but not every investor pulls back from actively investing in the market. And in particular, there is a consortium of investors that trade with more of a momentum bias that saw yields moving higher and invested in that direction. That, of course exacerbated the move. And of course, this was all occurring ahead of a very important event, which was the inauguration of President Trump. There was a lot of concern amongst investors about exactly what the executive orders would entail for key issues like trade policy. And so there was, I think, a buyer's strike in the government bond market, really until we got past the inauguration. So, Mike, with that background, can you help investors understand the process by which legislation and its deficit impact will be decided? Are there signposts to pay attention to? Perhaps people and processes to watch?

[Michael Zesas]

Yeah. So the starting point here is Republicans have very slim majorities in the House of Representatives and the Senate. And extending these tax cuts in the way Republicans want to do it probably means they won't get enough Democratic votes to cross the aisle in the Senate to avoid a filibuster. So you have to use this process called budget reconciliation to pass things with a simple majority. That's important because the first step here is determining how much of an expected deficit expansion that Republicans are willing to accept. So procedurally then, what you can expect from here is the House of Representatives take the first step probably by the end of May, and then the Senate will decide what level of deficit expansion they're comfortable with, which then means really in the fall we'll find out what tax provisions are in, which ones are out, and then ultimately what the budget impact would be in 2026. But because of that, it means that between here and the fall, many different fiscal outcomes will seem very likely, even if ultimately our base case, which is an extension of the TCJA with a couple of extra provisions, is what actually comes true. Given that, Matt, would you say that this type of confusion in the near term might also translate into some variance in treasury yields along the way to ultimately what you think the endpoint for the year is, which is lower yields from here?

[Matthew Hornbach]

Absolutely. There's such a focus amongst investors on the fiscal policy outlook that any volatility in the negotiation process will almost certainly show up in treasury yields over time.

[Michael Zesas]

Got it.

[Matthew Hornbach]

On that note, Mike, one more question. Could you walk me through the important upcoming dates for Congress that could shed light on the willingness or ability to expand the deficit further?

[Michael Zesas]

Yeah. So I pay attention to this March 14 deadline for extending stopgap appropriations because there will likely be a lot of chatter amongst Congressional Republicans about fiscal expectations and this type of thing that could feed into some of the volatility and perception that you talked about, which might move markets in the meantime. I still think most of the signal we have to wait for here is around the reconciliation process, around what the Senate might say over the summer, and then probably most importantly, the negotiation in the fall about ultimately what taxes will be passed, what that deficit impact will be. And then there's this other variable around tariffs which can also create and offsetting impact on any deficit expansion. So still a lot to play for despite that near term deadline, which might give us a little bit of information and might influence markets on a near term basis.

[Unnamed Speaker]

Great.

[Matthew Hornbach]

Well, Mike, thanks for taking the time to talk.

[Michael Zesas]

Matt, great speaking with you. And as a reminder, if you enjoy thoughts on the market, please take a moment to rate and review us wherever you listen and share thoughts on the market with a friend or colleague today.

[Unnamed Speaker]

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