Tax Hikes Alone Won’t Pay for Biden’s Budget Plan. The Bond Market Will Need to Pick Up the Slack.

President Joe Biden’s first full-year budget envisions spending $6 trillion in the next fiscal year, with trillion-dollar deficits as far as the eye can see. That reminded the debt market of the endless supply of bonds it faces. It also highlights that Uncle Sam’s finances depend on the current historically low interest rates—just like near-record stock prices and the red-hot housing market.

They’re all hooked on cheap borrowing.

The actual budget was released Friday afternoon, just before the three-day Memorial Day weekend and the start of a congressional recess. The timing is significant, Goldman Sachs economist Alec Phillips observed earlier, suggesting it might draw less attention to the spending plan than would be generated by a traditional Monday morning release.

In reality, the proposal is “aspirational,” argues Greg Valliere, the chief U.S. strategist at AGF Investments. “Biden knows he can’t get all of this stuff, but he wants to convince the progressives that he’s on their side. He needs to keep them happy, because they won’t like the inevitable compromises Biden will have to make with Manchin and the GOP,” the longtime Washington watcher writes in an email, referring to Sen. Joe Manchin, the Democrat centrist from West Virginia, and the Republican opposition in the evenly divided Senate.

Even so, there’s probably less new in the $6 trillion plan than meets the eye, Phillips writes in a research note. Starting with the Congressional Budget Office’s $5.05 trillion spending baseline for the year beginning Oct. 1, the American Rescue Plan (the $1.9 trillion measure passed this year) adds $529 billion to fiscal 2022.

The White House already has sent to Congress a request for $118 billion in additional discretionary spending, which brings the total to $5.7 trillion. The additional $300 billion probably reflects the effect of the roughly $4.4 trillion Biden has proposed in the American Jobs Plan and the American Families Plan.

What caught the stock market’s attention is The Wall Street Journal’s report that the budget assumes the capital-gains tax would be raised retroactively to April 28. The revised levy would hike the federal rate on long-term capital gains for individuals earning over $1 million annually to the same rate as ordinary income.

The AFP also would boost the top tax bracket to 39.6%, where it stood before the Tax Cuts and Jobs Act of 2017 lowered it to 37%. If the 3.8% surcharge for the Affordable Care Act were added in, the new capital-gains rate for million-dollar earners would be 43.4%, up sharply from the current 23.8%.

As this column noted a few weeks back, the capital-gains tax hike isn’t a done deal. And the effective date is likely to be a subject of intense lobbying, writes Brian Gardner, chief Washington policy strategist at Stifel. Most other tax measures would probably take effect next Jan. 1, he adds in a client note.

Gardner thinks chances are high that Congress will agree to some capital-gains tax increase, but a smaller one than the White House proposes. Twenty-eight percent—the rate in force from 1986 to 1997—seems more likely, he adds, a view shared by some other observers. Given that only 25% of U.S. equities are held by investors subject to the levy, the impact of a moderate increase probably would be muted. (The rest of U.S. stocks are held by retirement funds, endowments, and non-U.S. investors.)

While the bond market is wary of the Biden fiscal plans, which would raise the federal debt to 117% of gross domestic product by the end of the decade, Treasury Secretary Janet Yellen is playing down the risks.

She told the House Appropriations subcommittee Thursday that the administration’s proposals were fiscally responsible because, in part, the real interest-rate burden is negative. That’s because the yield on long-term Treasury securities of 1.60% is below the 2% inflation target. The real interest cost is a better measure of the debt burden than the debt-to-GDP ratio, Yellen contends. (As measured by 10-year Treasury inflation-protected securities, or TIPS, the real yield for that maturity is minus 0.84%.)

But that’s only because of the current extraordinarily low negative real interest rates, counters Lawrence Summers, the former Treasury secretary in the Clinton administration and an outspoken critic of his fellow Democrats’ fiscal plans. The Federal Reserve has set its short-term rate target near 0% while also keeping a lid on longer-term rates with its massive securities purchases, he said in a video meeting of the Economic Club of New York Thursday.

Summers reiterated that the Biden spending plan risks “overheating” the economy, which he says will return to its trend growth at full capacity by the end of the summer. At the same time, both the “monetary and fiscal accelerators are pressed to the floor,” which could trigger an inflationary surge that would be more than transitory, as Fed officials insist the current price rises are. And while the Biden plans envision tax hikes, Summers said the levies would be “backloaded” and wouldn’t address the short-term overheating risk.

But ultimately the flaw in Biden’s budget is that it relies on what Valliere calls “a very shaky premise” that debt-servicing costs can be contained. In fact, he argues, demographics will drive the national debt above $30 trillion as baby boomers retire, boosting Social Security and Medicare outlays.

“Thus, it appears that the only way this spending binge can be accommodated is if interest rates stay unusually low,” Valliere writes in a client note. By keeping its short-term rate target low, possibly near 0%, into 2023, the Fed under Jerome Powell has been willing to “go big,” he continues, shooting for “maximum employment” and inflation running above its putative 2% target.

But if the economy overheats from supercharged monetary and fiscal policies, as Summers expects, the question is: When will the market’s appetite for the bumper crop of bonds become sated?

“That’s the flaw in Biden’s budget,” Valliere contends. “If the Fed allows the economy to overheat, and spending continues to surge, interest rates inevitably will have to rise; the issue is whether they will rise moderately or rise dramatically.”

Back in the early days of the Clinton era, Democratic adviser James Carville famously observed: “I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.”

That observation may take on new life in a Biden administration.

For its part, the stock market didn’t evince any concern about the nation’s long-term fiscal health. The major indexes all rose in the past week, although the Nasdaq Composite’s gains weren’t enough to put the technology-dominated gauge into the plus column for the month of May.

Heavy inflows into equity funds continue, with the $17.9 billion in the latest week bringing 2021’s total to $512 billion, according to a report from Bank of America’s strategy team, led by Michael Hartnett. In fact, the amount that the bank’s own private clients poured into equities was the fourth-biggest since 2012. Such signs of exuberance have contrarians’ antennae aquiver.

Ditto for some anecdotes about rising speculative interest among investors. In a client note, Strategas Investment head Jason DeSena Trennert relates that an old buddy from his hometown on Long Island texted him in mid-April that he was “thinking of buying crypto, is it risky?” That was right when Bitcoin hit $62,284. By the time Trennert’s note was published Friday, it had tumbled by 38%.

His friend’s query might have rung the proverbial bell—like the previous ones that signaled tops for biotechs, airlines, and Sirius Satellite Radio in 2000, when the Nasdaq bubble was about to pop.

Air also has come out of other sectors pumped up by exuberance, rational and otherwise, and the free money from the Fed. Based on their recent highs, Trennert notes, the IPOX SPAC Index was down 24.5%; the Invesco Solar exchange-traded fund (ticker: TAN) was off 35%; the ARK Innovation ETF (ARKK) was down 28%; and Tesla (TSLA) had slid 29%. Restoring a bit of calm in such speculative sectors would help the sustainability of the bull market, he concludes.

Instead, the frenzy returned to the so-called meme stocks this past week, with GameStop (GME) jumping 25.6% and AMC Entertainment (AMC) soaring 114.7%. These names are sometimes viewed as outliers and even an asset class unto themselves. But their inflated values have pushed these previously insignificant shares into the market mainstream.

GameStop is now the second-largest holding, and AMC the eighth-largest, in the iShares Russell 2000 ETF (IWM), which tracks the most popular gauge of small-cap stocks thought to represent mainstream U.S. industries.

All the stars have aligned for the equity market, including maximum monetary and fiscal stimulus; peak economic growth, with Manufacturing and Services Purchasing Managers indexes at highs; plus benign financial barometers, with high-yield credit spreads historically low and volatility subdued, as indicated by the Cboe Volatility Index, or VIX, in the teens. Those indicators suggest that the easy money has been made, writes BCA U.S. equity strategist Anastasios Avgeriou. “Our sense is that the next 10% move in the [S&P 500] is lower (close to 3800) rather than higher,” he concludes.

Investors would do well to take some profits to raise cash for better opportunities later this summer.

Write to Randall W. Forsyth at randall.forsyth@barrons.com