Risk free no more

We will wait to see the market reaction on Monday to the downgrade, but I would venture to say that most to the impact to the news was already discounted. The question is what happens next. I would venture, as well, to think that the Trump administration will not stop or change anything on the tax plan because of the downgrade. Likely, they would double down and present it as the solution, although in its current form, it will deficit accretive. And then there is the possibility of a recession, and the other side of the coin, the monetary policy, where the president keeps pressuring to lower rates to avoid the outcome he’s contributing to create. But if you look at the chart below, the dynamics between monetary and fiscal policy during a recession, are also deficit accretive. During a recession, companies earn less money and therefore pay less taxes and, historically, on average the deficit widens $1.2Tn, while you get a positive impact of $230Bn for each 100 bps of cuts. In other words, you would need 500 bps in rate cuts to compensate for the loss on the fiscal side. Since we have rates at 4ish%, if we take this chart to the dot, the US will need QE again to get out of the mess. For 100 years, the U.S. has provided the world with a very important tool: the risk free rate. That is no longer the case.

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