Bad enough that we have to worry that any further Fed fund rate reductions will lead to increases in long bond rates. That happened with the September 18 50 basis point cut, since investors regarded the move as inflationary.
But further Fed cuts or no, it looks like we will see more upward pressure on bond yields. A Bloomberg story today informs us that the Treasury has a very big calendar of auctions in store, courtesy the growing US fiscal deficit. More supply means lower prices, hence higher yields. Indeed, since the Treasury will be selling more paper of all maturities, including bills, there will be pressure even at the short end of the yield curve.
Government auctions of bills, notes and bonds in the fiscal year that started this month may rise more than 50 percent to $220 billion, according to UBS Securities LLC, one of the 21 primary dealers that underwrite Treasury auctions. The first decline in corporate tax revenue since 2003 increased the shortfall by 12 percent to $162.8 billion for the year ended in September, from $144.8 billion in the 12 months through April.
With the Federal Reserve cutting interest rates to keep the economy from falling into recession and inflation slowing, an increase in net sales would mar an otherwise bullish outlook for U.S. government debt, which has returned 4.3 percent this year, Merrill Lynch & Co. index data show. Less than six months ago, Treasury officials credited a shrinking deficit for allowing them to eliminate sales of three-year notes.
“Unless the economy turns on a dime and starts to show strength again, we’re going to be looking at increased Treasury issuance beginning with bills later this year and spreading out across all Treasuries beginning in the first quarter,” said William O’Donnell, head of U.S. government bond strategy at Zurich-based UBS AG’s securities unit in Stamford, Connecticut.
UBS, whose economists are ranked the best on Wall Street in the latest poll by Institutional Investor magazine, forecasts a $225 billion deficit in fiscal 2008.
The difference for fiscal 2007 was the smallest in five years as tax revenue increased and spending rose at the slowest pace of George W. Bush’s presidency.
The improvement may be short-lived. The average estimate of UBS, Barclays Capital Inc., Banc of America Securities LLC, RBS Greenwich Capital Markets Inc. and Wrightson ICAP is for the shortfall to widen to $196 billion this fiscal year. All are primary dealers, except Wrightson, a Jersey City, New Jersey- based research firm specializing in Treasury finance.
The Concord Coalition, an Arlington, Virginia-based nonpartisan group that advocates a balanced budget, said it expects the deficit will continue to grow, exceeding $500 billion by 2013, if tax cuts slated to expire in 2010 are extended and spending increases at its historical rate….
A National Bureau of Economic Research study in 2005 found that a 1 percentage point increase in the deficit as a share of gross domestic product, lasting for three years, adds 0.40 percentage point to 0.50 percentage point to 10-year note yields.
The deficit shrank to 1.1 percent of GDP in April and widened to 1.2 percent in September, according to Louis Crandall, the chief economist at Wrightson. The midpoint of Crandall’s forecasts for fiscal 2008 is $200 billion, or 1.4 percent of estimated GDP over the period.
“With that framework, they will probably need to raise note sizes for the first time in some years by the end of the fiscal year,” Crandall said.
The government reduced sales of Treasury securities to about $142 billion in fiscal 2007 from a peak of $379.5 billion in fiscal 2004. The supply of marketable government debt rose 3.5 percent last year, the smallest increase since 1997.
Treasury bills, securities maturing in less than a year, were cut the most. Fewer bills were sold in fiscal 2005 and 2006 than matured, shrinking the supply by a $50 billion. The government decided in May to discontinue sales of three-year notes in part because officials said they wanted to “rebuild” issuance of bills.
The government retired $147 billion of the securities during the third quarter of fiscal 2007, helping to fuel a rally that pushed the yield on three-month securities to a 14-month low of 4.5 percent on June 18. That was less than a week after the 10-year note’s yield rose to a five-year high of 5.32 percent….
“Between the slowdown in the economy and all the financial market turmoil,” as well as the drop in corporate income tax receipts, “we have nudged our deficit forecast up,” said Stephen Stanley, the chief economist at RBS Greenwich in Greenwich, Connecticut.
Three months ago, Stanley forecast a fiscal 2008 gap of $140 billion. It now appears likely to be about $180 billion, he said….
“We have finally hit a point where the next change in auction sizes is likely to be up rather than down,” Michael Cloherty, head of U.S. interest-rate strategy in New York at the securities unit of Bank of America, wrote in an Oct. 4 report. The firm revised its forecast for the fiscal 2008 deficit to about $175 billion from $120 billion in April….
“It wasn’t too long ago that there was talk of potential buybacks being up for discussion at the Treasury,” said Pond, the Barclays strategist. “That speculation was a bit unfounded.”