Although Congress agreed on a short-term deal to avoid a shutdown, the increase in the deficit and lack of fiscal discipline may concern investors in the long run.

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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, October 2nd at 11 a.m. in New York. So let's get after it. 

This past weekend, Congress agreed to a last minute deal to keep the government open for the next six weeks. On one hand, avoiding a government shutdown is a net positive for the equity markets. However, on the other hand, the government is showing very little fiscal discipline will likely weigh on bond markets, which could then reverberate through stocks. This past August, I wrote a note and recorded a podcast asking if the U.S government may have hit a fiscal wall. One of the biggest surprises this year for investors has been the monumental increase in the fiscal deficit. More specifically, over the past 12 months, the fiscal deficit has increased by $1.3 trillion. This has supported better economic growth and may have kept the U.S. economy from entering a recession that many thought was unavoidable earlier this year. 

But now the piper must be paid. With the U.S. Treasury expected to issue close to $2 trillion in new supply in the second half of the year, the bond market has taken notice. While front end interest rates have been generally stable over the past several months on the expectation the Fed is very close to ending its rate hikes, the longer end of the Treasury market continues to trade very poorly, with ten year yields reaching 4.7%. With inflation expectations relatively stable and economic growth showing signs of slowing, we think this move in ten year yields is directly related to an earlier question. Has the US government pushed a limit of its ability to spend without proper long term fiscal discipline and funding in place? 

I think it's a reasonable question to ask even though we all know the Fed will likely provide the money necessary for the government to meet its obligations, especially in the short term. But now there is some growing doubt on the sustainability of such programs. The bond term premium has been suppressed over the past decade through quantitative easing and insatiable demand from foreigners looking to store their savings in a reliable place. But with the Fed no longer doing QE and even shrinking its balance sheet, banks unable to step up and buy and foreigners starting to diversify away from the US dollar, it's unclear who will be the natural buyer of this significant new supply. 

Lack of funding is a risk that markets have not had to think about when budget deficits get a bit out of control. In fact, the last time this happened was 1994, when ten year Treasury yields increased to 8%. The result was one of the biggest belt tightening exercises enacted in a bipartisan manner. Congress really had no choice at that time but to acquiesce to the demands of the bond markets. Could we be looking at a similar response this time? Like many Americans and investors, I have my doubts any real fiscal discipline will be enacted proactively. This just means the bond market may have to push back even harder to get legislators attention. Of course, that would not be good for already elevated equity valuations. The alternative is that Congress gets ahead of it and cuts spending, raises taxes or both, which would arguably be bad for growth. Bottom line, this conflict between markets and policy is nothing new, but this time it's centered around fiscal rather than monetary policy. More importantly, both potential outcomes, higher rates or smaller budget deficits, are likely bad news for stocks in the short term. 

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