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Fortunes changed dramatically this week as the Democrats swept the two Senate runoffs in Georgia on Tuesday, giving them control in the Senate in the form of soon-to-be Vice President- Harris’ tie-breaker vote. Suddenly, the anticipated soon-to-be-President Biden’s legislative agenda, which highlights significantly more fiscal spending on COVID-19 relief, is now in reach for the Democrats.
Perhaps a greater influence for the Democrats came on Wednesday with the shocking assault on the nation’s Capital Building as a mob took siege to both Congressional chambers, resulting in five deaths. Many on both sides of the aisle have stated that the mob was egged on by President Trump’s refusal to accept the results of November’s election, and increasingly desperate attempts to overturn the election of Joe Biden and Kamala Harris.
Suddenly, or at least temporarily, Republicans are on their back foot, as many Republican Senators and Congressmen were up until Wednesday backing the President in his claims that the election was stolen from him. Before losing their Senate majority, Republicans were digging their heels in with regard to additional stimulus spending. With the Democrats now holding the White House and both chambers of Congress (albeit with the slimmest of margins in the Senate), and Republicans in at least a temporary state of disarray over President Trump’s actions, greater spending is now a much more realistic scenario.
The Democrats in the Senate are now in control of all committees and sub-committees. With Senator Schumer taking over from Senator McConnell as Majority Leader, control over the schedule and agenda of what can come to the floor for a vote belongs to the Democrats. Taking over the leadership is a big deal, and, as we have seen since throughout our history, control of the Senate, even by the smallest margins, gives the party who has leadership tremendous power—especially when they also hold the Presidency.
What we find interesting is, it seems that the equity markets—as well as corporate credit and other risk assets—seem to be looking right past what they would consider the negatives of Democratic leadership, namely higher taxes and regulations and focusing on stimulus spending. The markets may be on to something as this current situation may be nirvana for them.
While standing in the way of higher COVID-19 relief will be difficult for any centrist Democrat, Senators like Joe Manchin of West Virginia and other “Blue-Dog” Democrats may very well fight tax increases and tighter regulations. All it takes is one Democrat to break ranks for a bill to fail in the Senate.
Additionally, there is still the filibuster in the Senate (unlimited debate) that can only be broken with cloture, which requires 60 votes (ten Republicans would have to break with their party) to end debate and bring a vote to the floor. Senator Mitch McConnell is a master of the Senate, and while no longer leader, is still a highly-skilled tactician when disrupting his opponent’s agenda.
Meanwhile, we wonder what will the Fed do in response to greater fiscal stimulus, something they have been desperately calling for all through 2020. Currently, to keep rates all along the yield curve low, the Fed is buying $80 billion Treasury notes and bonds a month as well as $40 billion MBS. The markets have been bombarded with Treasury supply since March 2020 and now that bombardment is going to get even bigger. Massive, new monthly supply of Treasury debt increases probably without additional revenue in the form of higher taxes, which, all else equal, means higher interest rates unless the Fed picks up the pace of Permanent Open Market Operations (POMO).
Will the Fed essentially fulfill a policy of monetizing debt by increasing their purchase of Treasuries (which they add to their now $7 trillion balance sheet) to control supply? Additionally, if they do increase the supply of Treasury purchases, will they continue to purchase $40 billion of MBS a month, or purchase less to offset an increase in Treasury purchases?
MBS has had one heck of a year in 2020, as evidenced by new record-low mortgage rates, record refinancing volumes, and bulging mortgage banker profits. However, nearly all of this fantastic performance comes directly from the Fed’s POMO. If the Fed takes their thumb off the scale even a bit, the MBS market may suddenly have a bit of a duration problem, reminiscent of the 2013 “Taper Tantrum,” even if we consider the fact the Fed now owns more than a third of outstanding Freddie, Fannie, and Ginnie MBS. If the demand for duration decreases and actually becomes a shedding of duration exercise, “Nirvana” for risk markets could end quickly. Will the Fed bail the markets out again in such a scenario? Probably.
It is going to be another very “interesting” year for the financial markets. The next couple of months will set the tone. Stay tuned.
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