Trump tax cut sounds great but markets are skeptical it would send interest rates flying

• The plan to cut corporate taxes was met with doubt because it could boost the deficit and drive up interest rates.
• The move is seen as the opening round in a battle to find a compromise tax plan in Congress.
• Bond traders immediately focused on the deficit ballooning aspects of the plan.

The plan from President Donald Trump's administration to cut the corporate tax rate by more than half was met with skepticism in financial markets because it could expand the federal deficit and send interest rates sharply higher.

But it was also seen as the opening round in a long battle to find a compromise tax plan in a divided Congress.

President Donald Trump looks on as Treasury Secretary Steve Mnuchin speaks at a signing ceremony at the Treasury Department in Washington, U.S., April 21, 2017.

Aaron P. Bernstein | Reuters

While equities markets might salivate over a 15 percent corporate tax rate, in the bond market, bond traders immediately focused on the deficit-ballooning aspects of the plan which, as yet, shows little ability to raise new revenue.

Some details on the plan were released by Treasury Secretary Steven Mncuhin and chief economic advisor Gary Cohn, who said the plan would also provide a tax break to repatriate corporate taxes from overseas, but did not reveal the rate as it is under negotiation with Congress.

"If this was a strong positive, we would be talking about the Trump reflation trade," said Jim Caron, fixed income portfolio manager at Morgan Stanley Investment Management. "Equities would be skyrocketing and bond yields would be moving higher ... there's a healthy dose of skepticism over whether this will pass. The bond market is skeptical and the equity market is trying to decide at this point."

The administration plan would also eliminate the alternative minimum tax.

"I don't know if it's a good plan or a bad plan, but what I'm trading on is how the narrative is set. Who will win the narrative? Will the left win the narrative? or will the Republicans win the narrative?" said Caron.

The individual tax rate would go to three rates — 10 percent, 25 percent and 35 percent from a current seven rates. There would also be fewer deductions but three would remain — charitable donations, homeownership mortgage deduction and retirement savings.

"It's a question of how they square the circle of wanting to have the drastic tax cuts and at the same time trying to convince Congress to pass it," said Peter Boockvar, chief market analyst at The Lindsey Group.

"To what extent can tax cuts pay for themselves in terms of generating more revenues than the taxes lost by the cut. The administration is going to assume it can generate a lot more revenue, and that it will essentially finance itself. Congress and historically Washington has always been skeptical of those promises."

Mnuchin and Cohn said many of the details are still being worked out.

"It will pay for itself with growth and the reduction of different deductions and closing loopholes," said Mnuchin during a briefing on the plan.

The current corporate tax rate is 35 percent, and House Republicans have their own plan to take the rate to 20 percent but with proceeds from a controversial border adjustment tax. The administration and House are also counting on revenue from the replacement of Obamacare, which could divert current tax monies used to pay for that program.

The plan from Trump does not include the border adjustment tax. The president floated the idea of a 15 percent tax rate as a candidate, and at the time it was estimated it could add trillions to the deficit.

"My read is that nobody is counting on this, nobody's expecting it. There are certain aspects of this that are not palatable to members of Congress. There are still in Washington within the GOP that vanishing breed of deficit hawks that have found their voice and they are finding it on the tax bills," said Scott Clemons, chief investment strategist at Brown Brothers Harriman.

Freedom Caucus members balked at changes to the health-care plan last month, and effectively kept the bill to replace Obamacare from coming to a vote. However, Freedom Caucus members on Wednesday announced they would support an amendment on a plan to repeal Obamacare.

The Trump plan was expected to include a 10 percent tax on repatriated earnings from overseas, which would hopefully provide some boost to the economy as corporations spend the cash at home. But Mnuchin said that is under discussion with Congress and he did not reveal a rate, only said it would bring back "trillions" from overseas.

But Clemons said he expects only $600 million to $700 billion of that more than $2 trillion to make its way back to the U.S.

"A lot of that cash is held offshore for reasons that has nothing to do with the tax structure," said Clemons. "That's an element of the plan that would have pretty good bipartisan support." He also said it might be something that could stand on its own, outside of a bigger tax plan, since it would be embraced by Congress.

After the Mnuchin and Cohn announcement at 1:30 p.m. ET, stocks were higher but cut their gains, and by the end of the session, the S&P 500 and Dow both closed slightly lower. The Nasdaq was flat. Bond yields were lower, with the 10-year trading at 2.30 percent.

"The bond market is going to be a daily measure on this issue. I think they're certainly questioning that he's going to get anywhere close to what he wants. If he did, [the 10-year yield] would be close to 2.60 on the upper end of the range, not 2.30 on the bottom end of the range," said Boockvar.

He said if such a plan were enacted, interest rates would adjust higher across the board, and they are already set to move up as global central banks move away from easing programs. Many economists expect the Fed to raise interest rates again in June.

"Trump is the 'art of the deal' negotiator. You start at the extremes and move to the middle. ... He's not doing anything when it comes to the deficit and trying to curtail it. These numbers are going to blow up the deficit," said Andrew Brenner, global head of emerging markets, fixed income at National Alliance.

Boockvar said companies would also be impacted by a deficit spending plan. "You can offset the benefits of the tax gain through the higher cost of capital. So much debt has been accumulated in the corporate sector in the last 10 years, people can't look at the tax cut in a vacuum," he said. "The bond market is going to be the tell on what they are thinking Trump will be able to actually pass and what the growth influence is and the deficit it's going to create."

According to Boockvar, as of the fourth quarter, total business debt in the U.S. was $13.47 trillion. He said if interest rates rose 100 basis points, or 1 percentage point, it could add about $135 billion in higher interest expense. For households, he estimated $147 billion of higher interest expense on everything from mortgages to credit cards, autos and student loans.

Boockvar said the stock market has been moving higher in anticipation of the tax plan since Trump won the election Nov. 8. He now expects a long haul through Congress, as the debate focuses on whether a tax plan has to be revenue neutral. The impact on the deficit would determine whether cuts can be made permanent.

The argument in favor of a plan that widens the deficit is that it would increase growth and could make the tax cuts self-financing by adding new tax revenue to the economy.

"If you have something permanent, you have to have it revenue neutral. This was just a starting point that Congress wanted the administration to lay out. Where health care is being debated within Congress, I think on the tax side people wanted Trump to create a starting point," said Boockvar.

Earlier Wednesday, Mnuchin said the White House wants a combined plan with the House and Senate. The Treasury secretary declined to provide details of the plan but called it "the biggest tax cut and largest tax reform in the history of our country."

Correction: The plan from Trump does not include the border adjustment tax. An earlier version misstated its status.