Bullish Breakout . . . In the U.S. Deficit

Conclusion:  The Federal Government released their budget numbers for January, and we continue to see expansion towards an all time high in the U.S. budget deficit.  The federal budget deficit is now expected to be $1.65 trillion for fiscal year 2011.


Position: Short Municipal Bonds via the etf MUB


The Treasury Department released its budget statement for the first four months of the fiscal year late last week and the results were indicative of a widening U.S. budget deficit.  In conjunction with this release, the White House took up its deficit estimates for fiscal year 2011 to ~-$1.65 trillion.  This puts the federal deficit squarely in the red zone of budget deficit-to-GDP of -10%.  In fact, based on our math and using the White House’s deficit projection for fiscal year 2011, budget deficit-to-GDP should be ~-10.9%, which is the highest level we’ve seen since World War II.


In the table below, we’ve compared key line items for the first four months of this fiscal year and the first four months of last fiscal year.  As always, we have normalized for TARP and 1-time payments.   There are a few year-over-year trends to highlight, which include:

  • On the outlays (or expenditures) side, Medicaid was up +7.9% and Net Interest on Public Debt was up +9.6%.  The latter point will be even more critical as debt expands to fund future deficits and interest rates continues to climb; 
  • The key positive for expenditures was  the decline in unemployment insurance payments, which declined (18.2%) year-over-year (albeit the savings was small relative to the entire deficit); and 
  • The primary positive change on the revenue side of the ledger was a +23.2% increase year-over-year on individual income tax revenue, which amounted to a net positive contribution of $72 billion for the period. 

Bullish Breakout . . . In the U.S. Deficit - 2


In aggregate, government outlays continue to accelerate, as they were up +6.6% on a year-over-year basis.  While revenues also expanded (up a healthy +9.4%, driven primarily by individual income tax receipts), it was not large enough growth from the smaller revenue base to narrow the year-over year budget deficit, which was up +1.9% to -$422 billion for the first four months of the fiscal year.


As we outlined in our conference call last week,Mayhem in Muni Bond Land,” one of our key short ideas as it relates to the burgeoning U.S. federal budget deficit are municipal bonds as an asset class.  The key implication of a larger-than-expected federal budget deficit is that there is less money available to offset state and local level budget deficits, which will require state and local governments to issue more debt to fund their operating budgets and capital expenditures.


The other key issue to consider is that as the federal budget deficit increases, the future supply of U.S. Treasuries will increase as well.  Naturally, a larger supply of Treasuries to be issued should demand a higher interest rate.  Since municipal debt, as outlined in the chart below, tracks the yields of U.S. Treasuries very closely, increasing supply in the Treasury market (and likely increasing yields) will be negative for the municipal debt market as well.


The last interesting point we wanted to highlight from the budget report relates to foreign aid.  According to the CBO:


“Those increases were partially offset by several large decreases, including a reduction of $2.4 billion in outlays for international security assistance, reflecting a delay in making most of the $3 billion in annual payments to Egypt and Israel for military aid.”


It is interesting to note the scale of these security payments, as well as the actual levers that the U.S. government can pull by delaying these payments.


Daryl G. Jones

Managing Director


Bullish Breakout . . . In the U.S. Deficit - 1

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