The Instability Beneath the Equipoise

With equity market valuations higher and credit spreads tighter than historical averages, risk perception in financial markets appears to reflect an economy in equilibrium. John Williams, president of the New York Fed, has described this as a state of “equipoise” in which the risks to employment and inflation in the US are balanced.¹

Certainly not in balance are the country’s fiscal settings, and, as a result, the federal deficit as a percentage of GDP remains historically outsized relative to the unemployment rate.² Normally, low unemployment rates and decent economic growth such as we have seen in recent years beget higher tax revenues and tighter fiscal policy—and thus budget deficits much smaller than the 6%-plus we’re at today.³ Nothing out of Washington suggests the current fiscal dynamics is likely to change anytime soon.

That said, persistent deficit spending has imparted some positive nominal drift to the economy, which has trickled down into corporate earnings and margins and supported financial markets. But the continuously expanding government debt pile has also raised the specter of currency debasement and other adverse financial outcomes. As shown in the table below, the upward bias in 10-year Treasury yields—after four decades of secular decline—may be manifesting these concerns.