Does the Fiscal Deficit Really Affect Asset Valuations?

How do investors respond to the state of the U.S. federal fiscal deficit? In their August 2007 paper entitled “Fiscal Policy and Asset Markets: A Semiparametric Analysis”, Dennis Jansen, Qi Li, Zijun Wang and Jian Yang examine the relationships between U.S. fiscal policy and U.S. asset markets (stocks and bonds). Using monthly data for the S&P 500 index, U.S. corporate bond yield, 10-year Treasury note (T-note) yield, the Federal Funds Rate (FFR), industrial production, the Consumer Price Index and the U.S. government budget deficit over the period July 1954 through December 2005 (618 months), they conclude that:

• The effects of the fiscal deficit on stocks and bonds are indirect via implications for monetary policy (e.g., FFR).
• Economic growth impacts the stock market more strongly when the fiscal deficit is shrinking (or the surplus growing), suggesting that investors see deficit control as supportive of sustainable growth.
• FFR hikes impact the stock market more strongly when the fiscal deficit is shrinking (or the surplus growing) than when the deficit is growing, suggesting that investors anticipate rate hikes when the deficit is growing.
• When the fiscal deficit is growing, an FFR hikes clearly boost the T-note yield. When the deficit is shrinking, the effect of FFR hikes on the T-note yield is much smaller.

In summary, the trajectory of the federal fiscal deficit significantly affects the way investors interpret economic growth and Federal Funds Rate hikes.

It’s a multivariate world.

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