It is budget season in Washington and rising budget deficits remain at the forefront of the economy and financial markets. On Monday, February 1, the Obama Administration proposed a $3.8 trillion budget package that would result in a further increase in the budget deficit to $1.6 trillion, much more than the $1.3 trillion announced last week by the non-partisan Congressional Budget Office (CBO). While an increase in the budget deficit was expected, the President’s proposed budget showed persistent, and still substantial, deficits in future years [Chart 1]. This relatively bleak outlook is of particular importance to bond investors since deficits are financed by the issuance of Treasury bonds. Record Treasury issuance has been a bond market fact of life for nearly a year now but investors continue to question what impact record deficits will have on the level of interest rates.
Investors fear a large and increasing deficit due to the ever-increasing amount of debt needed to finance the deficit. As the amount of debt grows, investors fear that massive debt issuance will require higher and higher interest rates to attract sufficient demand from investors. Not only might this lead to higher interest rates and lower prices for existing bond investors, but the higher interest rates might discourage private sector investment, which in turn might retard economic growth overall. How the private sector and financial market react to deficits is still a source of debate among economists, however, market history shows little correlation between deficits and the level of interest rates [Chart 2]. As the deficit began to deteriorate in late 2000 through 2003, interest rates actually declined. As the deficit was reduced from 2003 through 2007, the 10-year Treasury yield showed a modest upward bias, again contrary to what investors might think. In addition, since the federal deficit recently began to increase sharply recently in response to stimulus measures to counter the Great Recession, the 10-year Treasury yield is lower. Comparing the budget deficit as a percentage of GDP to the 10-year Treasury yield is useful since it takes the size of the deficit (or surplus) in terms of the output produced by the economy and compares this to the cost to service the national debt. This measure also produces no discernable relationship between the deficit and interest rates. Comparing the federal surplus that began under former President Clinton is perhaps most notable.
The federal government operated in surplus from early 1998 to early 2002, with the surplus peaking in early 2001 at 2.6% of GDP. The 10-year Treasury note yield averaged 5.4% over the period compared to a 4.1% average yield from February 2002 through January 2010. Despite a surplus, bond yields (interest rates) were higher compared to deficits from 2003 onward. Since the deficit is financed by selling bonds (which are repaid much later), outstanding debt as a percentage of GDP is a focal measure for bond investors. The greater the amount of debt relative to the size of the economy (GDP), the greater the debt burden is and the risk of not servicing that debt.
Japan Stands Out
On this front, Japan stands out as an argument against deficits leading to higher interest rates. At 160% of GDP, Japan’s debt-to-GDP ratio is by far the largest among developed countries yet 10-year Japanese government bonds yield a mere 1.3%. While a growing debt relative to GDP is certainly a negative, it is just one factor affecting the level of bond yields. Although a few years old, the most recent Federal Reserve study on deficits and interest rates cites the debt-to-GDP ratio as potential guide to the path of interest rates. The authors concluded that for every 1% rise in the debt-to-GDP ratio, long-term government bond yields would increase by 0.03% to 0.05%. However, the authors also stated the impact would be longer-term in nature and take three to five years to be fully reflected in interest rates. At the start of the financial crisis, the US debt-to-GDP ratio was 70% and is projected to peak near 100% in coming years, an increase of 30 percentage points. Applying the 30 percentage point increase to the expected 0.03% to 0.05% yield increase indicated by the Fed study shows the deficit will push interest rates up by 0.9% to 1.5% over three to five years. The 10-year Treasury currently yields 3.6% and implies that such a move would result in a 4.5% to 5.1% 10-year Treasury yield excluding other factors. While a notable change, it is hardly the level many investors fear in response to much higher deficits.
At a projected 9.9% of GDP, the U.S. federal deficit is unprecedented in modern times and we do not intend to dismiss the significance. As stated in our 2010 Outlook, we believe the absence of Fed bond purchases coupled with record Treasury supply needs is a negative factor for bonds later in 2010. However, inflation has historically had the greatest correlation to intermediate and long-term bond yields while the Fed has a greater influence on short-term yields. In Japan, persistent deflation has been the driver of very low government bond yields. We will continue to assess the deficit and subsequent Treasury issuance needs but it is just one factor affecting the level of interest rates. Treasury valuations and rates of returns on competing investments will also affect the level of interest rates. Expected real (inflation adjusted) economic growth also affects the level of interest rates. Lower real economic growth suggests lower investment returns and therefore lower yields. In our view, lower real economic growth in the 2000s, compared to the 1990s, contributed to low Treasury yields. We believe the main drivers of interest rates will continue to be inflation and the Fed but many factors ultimately contribute to interest rate levels.
- This report was prepared by LPL Financial. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
- Government bonds and Treasury Bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of funds shares is not guaranteed and will fluctuate.
- The market value of corporate bonds will fluctuate, and if the bond is sold prior to maturity, the investor’s yield may differ from the advertised yield.
- Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and are subject to availability and change in price.
- High yield/junk bonds are not investment grade securities, involve substantial risks and generally should be part of the diversified portfolio of sophisticated investors.
- International and emerging markets investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.
- Stock investing involves risk including loss of principal.
- Investing in mutual funds involve risk, including possible loss of principal. Investments in specialized industry sectors have additional risks, which are outlines in the prospectus.
- Municipal bonds are subject to availability, price and to market and interest rate risk is sold prior to maturity.
- Bond values will decline as interest rate rise. Interest income may be subject to the alternative minimum tax.
- Federally tax-free but other state and local taxed may apply.
- Mortgage-Backed Securities are subject to credit risk, default risk, and prepayment risk that acts much like call risk, where you get your principal back sooner than the stated maturity, extension risk, the opposite of prepayment risk, and interest rate risk.