Trading the Long Term Government Trend

In the United States, betting that government is going to grow is what some people might call a “positive carry trade”. A positive carry trade is a trade that makes money as long as things stay the way things are currently priced.  The growth of government under current conditions can easily be seen in data on projected spending levels from the CBO.

As spending levels increase, revenues are not at this time projected to rise to keep pace with earnings. There are a few ways that this extra revenue can be found.

1. More debt: The CBO currently projects that under current policies the US will have much higher debt levels in the future.

The trade based on these projections would be to sell short US government debt, as an increase in supply without a subsequent increase in demand should lower the price of an asset.

2. Inflating away the debt: A lot of people worry that the debt won’t be an attractive asset, so the government will have to raise money from seigniorage (issuing new government currency). The trades that make sense in this current situation are to buy gold and sell bonds. This scenario is what most people who worry about government spending often decide they need to focus on, so there is a question of whether there are too many people buying gold and selling bonds in the absence of any present fiscal crisis. However, if a fiscal crisis does occur it may be too late to put on any of these trades so it isn’t completely illogical for a person who thinks there is a higher probability of a fiscal crisis than other people admit to try and hedge their portfolio against the possibility.

3. Higher taxes: This is the least extreme case, though there are still investments that can be made if this occurs. Although the average US voter loves low taxes, they may decide that they like their entitlements more. The recent healthcare policy is a shift in the direction of more entitlements and higher taxes. This negatively impacts domestic growth while not having much of an international impact.  The fact that companies with more international exposure have outperformed companies with domestic exposure even when the dollar was strengthening could be attributed to the wave of new regulations in the US.


Source: Palantir Finance. For International/Domestic Index: GS International Growth Theme Index (68% of revenue from sales outside the US) divided by GS Domestic Sales Basket (less than 1% of its revenue from international sales)

4. Repeal of future entitlements: I’m not sure that this scenario is likely enough absent an inflationary shock to make it worth considering, but the basic scenario would make gold less attractive and while bonds might sell off due to higher future growth they would not be at risk of a major sell off.

2 responses
1. More debt: 2. Inflating away the debt 3. Higher taxes 4. Repeal of future entitlements

What’s interesting is each has serious natural constraints. More debt is monitored by the bond market, politicians, to some extent voters. Inflation is monitored by the Fed, holders of US debt, and voters anchored in 1970’s fear. Taxes are watch by republicans, some concerned dems, and definitely high-income earners. And entitlements are monitored by those who receive them. (all have many more interested observers obviously). Ranking them by likelihood is hard given the many uncertainties but some combination of all of them over time is not unreasonable. 1 is happening. 2 is difficult (short term maturities, China, effect of increased rates) but not impossible. 3 will happen. 4 should happen and may have to (increased age limit for SS?)

Trading “for” these outcomes could obviously backfire dramatically if we fall back into a recession, in which govt debt could become in high demand (depending on the cause). Separately, what makes trading these long term especially difficult (beyond the embedded uncertainty), is not the likelihood of the first effect, but the uncertainty re: the second order and third order effects... and their corresponding policy and behavioral responses.

Yah, other market movements can definitely move these trades even if the long term prediction about government spending is correct. For trades that are more dependent on leverage such as the short bonds trade, it is even more difficult to hold onto the position. The gold trade is popular because it is easy to hold on to, but people who believe in gold probably underestimate the chances of taxes going up.