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The Bond Column

Legislative Quagmire Presents Headwind to Reflation Trade
Updated: 2017-02-20, 08:55:21 ET
Analyst: David Kelland

This week's U.S. economic data was about the best the optimists could have hoped for and yet Treasuries ended the week virtually unchanged. The producer price index, consumer price index, and retail sales data for January all exceeded forecasts. Housing starts, building permits, and the regional manufacturing surveys also handily beat consensus expectations. The only significant report to disappoint was industrial production and the miss was entirely due to warmer-than-expected weather.

Two other factors -- hawkish comments from Fed Chair Yellen and a strong stock market -- also should have pushed interest rates higher. On Tuesday, Janet Yellen appeared before the Senate Banking Committee and made clear that the March 14-15 FOMC meeting is 'live.' She set the bar rather low for a decision to increase the Fed funds target range and she also said that the neutral rate will 'rise somewhat over time.' By that, she means that monetary policy will become more stimulative unless the Fed tightens policy. Yellen also highlighted fiscal stimulus as an upside risk to growth and inflation but did not cite specific downside risks.

The most obvious explanation for the strength of the Treasury market in the face of such headwinds is that Congress is stuck in a rut. The Republican party's thin majority in the Senate (52-48) means that the leadership needs to make use of budget reconciliation to avoid filibusters and there are many restrictions on that process. In short, there are reasons why a repeal or replacing of the Affordable Care Act has to happen before tax reform. For some obvious reasons, ACA repeal/reform is a lot more politically difficult than corporate tax cuts. A proposal to convert from a corporate income tax to a destination-based cash flow tax would put voters asleep rather than enrage them.

Furthermore, while the destination-based cash flow tax is quite economically efficient and could eliminate a lot of dead-weight economic losses in the form of tax engineering, there are always winners and losers. Importers are lobbying hard against a DBCFT because they are skeptical that the dollar will appreciate in value enough for them to maintain profitability. Lastly, the legality of a DBCFT under World Trade Organization rules is unclear. As for infrastructure spending, which could also boost growth and inflation, that appears to be below Obamacare and tax reform on the legislative agenda.

All of the hurdles to tax reform could eventually be cleared and a more experienced White House might have made things easier, but the swift passages of legislation in 2001 and 2009 appear not to be repeated.
Some of the reflation trade of the past seven months has been built on subsiding investor anxiety while some has come from optimism about U.S. fiscal and regulatory policy reforms helping the economy reaching a higher pace of growth than seen during the recovery until now. The stock market is certainly still on board with a big growth boom or at least an extended continuation of growth before another recession hits the U.S. economy. Treasury yields and the U.S. dollar, however, have hesitated since their respective highs in mid December and January 2.

The pass-through effects of rebounding oil prices into year-on-year price inflation will begin to fade after February and that too could begin to encourage buyers of Treasuries. I am not saying that I would buy government bonds but only that these are the things that would worry me as a bear. 

- David Kelland,