28 October 2002, 09:00  Return to Budget Deficits Won't Push U.S. Interest Rates Higher

/www.bloomberg.com/ By Michael McKee
Washington, Oct. 25 (Bloomberg) -- The $159 billion annual U.S. budget deficit announced yesterday, the first in five years, is unlikely to push interest rates higher because the shortfall remains small relative to the size of the economy and companies aren't competing with the government for money, economists said.
The government deficit recorded for fiscal year 2002, which ended Sept. 30, amounts to 1.5 percent of gross domestic product. The Congressional Budget Office has forecast the deficit will be $145 billion in fiscal 2003, which began Oct. 1. That would be 1.4 percent of GDP.
While the government is issuing more bonds to meet its obligations, even more were being sold after the recession of 1981- 82, when the deficit reached 5.6 percent of GDP -- yet interest rates have been falling.
The idea that deficits push up market rates is ``absolute poppycock,'' said Paul McCulley, who oversees about $90 billion for Pacific Investment Management Co. ``No evidence exists to support the proposition that fiscal policy expectations dominate the level of interest rates.''
A combination of increased spending after Sept. 11, tax cuts, and a stock slump that cut capital gains tax receipts means the government has been spending more than it's taken in for a year. Yet the yield on the 10-year Treasury note, which has replaced the 30-year bond as the nation's benchmark, reached a 44-year low of 3.57 percent on Oct. 9. It was at 4.12 percent today, compared with an average 4.71 percent for this year.
The government also sold $40 billion in five-year and 10-year notes in August, close to a quarterly debt-sale record. The yield on 5-year notes was 3.348 percent, the lowest ever, and the yield on 10-year notes 4.39 percent, the lowest in nine months.
Bond `Vigilantes'
``Bond market vigilantes have not formed a posse for another ride against fiscal imprudence,'' said Susan Hering, an economist at UBS Warburg.
Conventional wisdom holds that an increasing supply of government securities ``crowds out'' other issuers, forcing them to raise yields to attract buyers. That won't happen with today's deficits, said Paul DeRosa, who was head of proprietary bond trading for Citigroup Inc.'s Citibank in the 1980s, when the tax cuts and higher government spending of the Reagan years created a sea of red ink.
``The numbers they're talking about now are minuscule,'' DeRosa said. ``It's unlikely these deficits are going to have any material impact.'' DeRosa is now a partner at Mt. Lucas Management Co., a hedge fund.
Private sector economists said the fiscal 2003 deficit could be as high as $184 billion, which would amount to 1.7 percent of GDP. The shortfall was 4.1 percent of GDP in 1992, $290 billion, following the last recession. At that time, the yield on the 30- year Treasury bond had fallen by half, to an average 7.66 percent that year, from a high of 15.2 percent on Oct. 26, 1981.
Mortgage Rates Fall
Market interest rates tied to yields on Treasury securities have dropped even as the deficit has widened this year. The average rate on a 30-year fixed mortgage fell to 5.98 percent in the week ending Oct. 11, according to Freddie Mac, the No. 2 buyer of U.S. mortgages. That's the lowest since the group began keeping track in 1971. Automakers are offering zero-interest loans. And the prime rate is currently at 4.75 percent, down from 21.5 percent in December 1980.
``Historical analyses show little consistent relationship between the deficit and interest rates,'' said Louis Crandall, chief economist at Wrightson Associates in New York.
Another reason the current deficit isn't likely to push yields higher is that the supply of Treasury securities won't increase much this year because the amount of maturing Treasury debt that has to be paid off falls by almost $100 billion in fiscal 2003, according to researchers at RBS Greenwich Capital Inc.
Questioning Forecasts
``If Treasury keeps the current issuance schedule, they can raise well over $200 billion without increasing bond sales further,'' said Stephen Stanley, a Greenwich economist who tracks the fixed-income market.
Some analysts say rates will rise because the government's deficit forecasts are too low. Ian Shepherdson, chief U.S. economist at High Frequency Economics Ltd., predicts the fiscal 2003 deficit will be $350 billion, more than twice as high as the CBO forecast.
``I don't expect this to blow bond yields out,'' Shepherdson said. ``But I would expect yields to come under some pressure,'' increasing if the deficit forecasts are too low.
Federal Reserve Chairman Alan Greenspan warned Congress last month yields might rise if deficits become a way of life and investors lose faith in congressional and administration predictions of a return to surpluses in fiscal year 2006.
`Long-Run' Connection
``Returning to a fiscal climate of continuous large deficits would risk returning to an era of high interest rates, low levels of investment, and slower growth of productivity,'' Greenspan told the House of Representatives Budget Committee.
``I'm in the camp which believes in a very close connection over the long run'' between deficits and interest rates, he said.
And Robert Hormats, vice chairman of Goldman Sachs International said at some point companies will start to borrow and that will push up rates as they compete with the government for money. ``Corporations aren't borrowing a lot right now because they've got excess capacity and are not making a lot of new investments,'' he said.
Most analysts say there's no way to predict the path of the deficit more than a few years ahead. A year ago, forecasters were still expecting a surplus. Nor is there any way to tell how large the deficit would have to be for government borrowing demands to start having an effect on rates.
`Not Worth Speculating'
``It's impossible to quantify'' said John Youngdahl, an economist at Goldman Sachs. ``By that time we could be in completely different state of affairs, so it's not worth speculating on.''
One thing all economists and investors agree on is that some consumer and business borrowing costs will rise as the economy improves, because the Fed will have to push interest rates up to keep the economy from overheating and inflation from accelerating. Inflation erodes the value of bonds.
The drop in the yield on the 30-year bond after 1981 reflected the Fed's successful fight to bring inflation under control. In January 1981, consumer prices were rising at an 11.8 percent annual rate. By contrast, in the 12 months through July of this year, the consumer price index was up just 1.5 percent.
``This is normal,'' said James Glassman, chief U.S. economist at J.P. Morgan Chase. ``Overall, rates are guided by the health of the economy and inflation.''

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