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In the United States, two events could change the trajectory of fiscal policy in 2021: the need to raise the debt ceiling and the coming expiry of key corporate tax breaks. These events could introduce volatility into markets generally, but for bond investors, they may be an opportunity, per Morgan Stanley.

Key quotes

“On the debt ceiling, the need to approve an increase in the US’s self-imposed Treasury issuance cap has been a flashpoint for budget negotiations in the past, most notably in the summer of 2011, when it was used by members of Congress to demand future spending cuts. We’re watching for something of a repeat of that phenomenon if Republicans maintain control of the Senate. If they do, negotiations over the debt ceiling, which may need to be raised in August, could become a vehicle to demand cuts in government spending. Fiscal contractions like these, depending on the economic context, could decrease future economic growth expectations, putting downward pressure on bond yields.”

“On corporate tax breaks, starting in 2022, the deductibility of interest becomes more constrained. Businesses will also have to deduct research and development in software costs over five years. In 2023, upfront deductibility of capital investment begins to phase out. Together, these policies would meaningfully increase corporate taxes. Unless a compromise is struck to extend these breaks, the result will be a modest fiscal contraction, which again, depending on the economic context, could put downward pressure on bond yields.”

“Since we expect much of 2021 will be about a continued strong economic recovery as the US emerges from the COVID-19 recession, we also expect a material increase in bond yields and falling bond prices along the way. If that ends up being correct, then this late-year concern on the US fiscal outlook could be an opportunity for a good entry point and stable returns.”