Soaring Deficits Expected to Keep Mortgage, Bond Yields Climbing

Author: Loren Steffy

Published: August 29, 2003

As the U.S. government enters a new fiscal year on Oct. 1 looking to finance a record $475 billion budget deficit, the bond market has spoken: The days of easy money are over.

The $3.3 trillion U.S. Treasury market is coming off its worst rout since 1980. Since mid-June, the price of 10-year notes has slid more than 8 percent, causing yields to soar. Ten-year yields -- benchmarks for pricing corporate loans and home mortgages -- climbed from 3.07 percent to a one-year high of 4.66 percent on Aug. 14, though it's slipped some since then.

The spillover has been even more apparent in mortgage rates, with the average 30-year fixed-rate mortgage rising from 6.28 percent last week to 6.32 percent this week, the second-highest in a year, according to Freddie Mac, the second-largest source of home-loan financing, yesterday. Mortgage rates have risen nine weeks out of the past 10 after reaching a record-low 5.21 percent in June.

"This could be the beginning of a long-term rise in interest rates," said Christopher Low, chief economist at FTN Financial in New York, the top bond underwriter for U.S. mortgage giants Fannie Mae and Freddie Mac.

Bond investors have sent Treasury rates soaring even as the U.S. Federal Reserve has kept its benchmark overnight rate at its lowest level since the 1950s. In a bid to spur the economy, the Fed left the federal funds rate at 1 percent, a 45- year low, on Aug. 12.

Some investors fret that those low rates and $1.7 trillion in tax cuts by President Bush may rekindle inflation along with growth. That would hurt fixed-income securities at a time when the Treasury is selling record amounts of debt. In the last three months of 2003, the Treasury plans to auction $126 billion of bills and notes -- its largest round ever.

For Wall Street, finding buyers for those securities may not be easy. An investor who bought $10 million of 10-year Treasuries in mid June had lost $1 million by early August. U.S. mutual fund investors withdrew a net $3.6 billion from taxable bond funds during the week ended Aug. 6 -- the biggest outflow in more than nine years, according to AMG Data Services, which tracks the fund industry. And the Investment Company Institute yesterday reported that bond funds saw a net $10.84 billion walk out the door in July, the first monthly net outflow since December 2001.

To lure investors to coming auctions, the 22 Wall Street firms participating in Treasury sales -- the primary dealers -- may have to sell government securities in order to boost yields further still.

"They want to make sure they can sell all those bonds; they don't want them, " said Gary Pollack, who helps manage $10 billion of fixed-income securities at Deutsche Bank AG in New York.

As the U.S. deficit swells, the Treasury will have to compete with the governments of Japan and Germany for investors.

German Chancellor Gerhard Schroeder faces a projected 15.6 billion euro ($17.6 billion) budget shortfall in 2004 and wants to pay for tax cuts by selling 29 billion euros of debt.

In Japan, Prime Minister Junichiro Koizumi pledged to cap annual government bond sales at 30 trillion yen ($252 billion) and then broke his promise because of slumping tax revenue. Koizumi's government plans to sell 36.4 trillion yen of debt in the fiscal year ending on March 31, 2004.

Global investors have at least one incentive to buy Treasuries: higher yields. In mid-August, 10-year Japanese government bonds traded at a yield of 0.93 percent, and 10-year German government bonds paid 4.17 percent.

Even so, the $5.5 trillion global market for dollar-denominated debt may be stumbling at the very moment the U.S. Treasury needs credit.

Paul McCulley, a managing director at Pacific Investment Management Co. in Newport Beach, Calif., says the bond market is likely to muddle along for a while -- and then turn bearish as the U.S. economy gathers steam.

"Looking out over the next three, four years, I think you will have a bear," said McCulley, who helps manage $100 billion at Pimco. The U.S. deficit is likely to get worse before it gets better, he said.

In projecting the $475 billion gap for fiscal 2003-04, the White House has excluded the cost of the war in Iraq -- a figure that could easily add $60 billion to the deficit in the new fiscal year, says Robert Bixby, executive director of the Arlington, Va.-based Concord Coalition, a nonpartisan group that advocates for a balanced federal budget.

The deficit would balloon further still if Congress extends Bush's tax cuts, which are scheduled to expire by 2010, Bixby says. "The deficit projections are substantially understated," he said.

Economist William Gale, a senior fellow at the Brookings Institution in Washington, says the U.S. budget deficit will soar in coming years unless the government checks it now. As baby boomers begin to retire, the government will confront rising costs of medical care and other entitlements.

"The deficit is not the wolf at the door; it's more the termites in the woodwork," Gale said.

If he's right, America's ballooning budget deficits may have only begun to gnaw at bond investors' wealth.