For Bond Owners, Worries Add Up

Owners of long-term bonds are supposed to have correspondingly long memories. That can be helpful in maintaining a realistic view of the risks inherent in fixed-income securities.

Those long memories may have kicked in last week, after the Bush administration announced its new estimates for the federal budget deficit this year and next.

The deficit for the current fiscal year now is expected to be $455 billion, up from the White House’s previous estimate of about $304 billion. For fiscal 2004, which begins Oct. 1, the new deficit estimate is $475 billion, up from $307 billion.

In nominal dollar terms, the nation never has recorded red ink on this scale. The previous record was the $290-billion deficit of fiscal 1992, the final year of George H.W. Bush’s presidency.

The deficit revisions were announced Tuesday, the same day Federal Reserve Chairman Alan Greenspan was giving Congress his updated forecast for the economy. For the bond market, Greenspan and the White House amounted to a one-two punch: The Fed chief sounded relatively optimistic about the outlook -- which could mean that interest rates have bottomed -- while the deficit data ensured a massive supply of new bonds coming down the pike.

The result was a sell-off in bonds and a surge in yields. By week’s end, the yield on the 10-year Treasury note, a benchmark for other long-term interest rates, was at 4%, up from 3.63% a week earlier and the highest since April 14.

Exactly what makes bond yields do what they do on any given day always is subject to conjecture. But suffice to say, many bond owners are substantially more worried about their investments today than they were, say, in early June.

If market rates on new Treasury bonds keep going up, existing fixed-rate Treasuries will be devalued. That’s a certainty.

Some bond investors last week may have been remembering the last times the subject of a ballooning deficit was a hot topic on Wall Street. In the mid-1980s and again in the early 1990s the deficit was soaring, and a primary focus of economists and investors was the potential for unrestrained federal borrowing to “crowd out” other borrowers and drive interest rates sky high.

It was a reasonable concern -- but it proved false.

As the deficit stayed in the then-record $200-billion-a-year range from 1984 through 1986, the 10-year T-note yield plunged from nearly 14% to 7.2%.

From 1990 through 1993, the deficit mounted from $221 billion to $290 billion -- yet the 10-year T-note slid from 8% to 5.8%.

Neither did the stock market seem too worked up about the deficits of those eras. The Dow Jones industrial average rose 51% from the end of 1983 to the end of 1986, and 43% from the end of 1990 to the end of 1993.

No wonder the Bush administration last week described the projected 2003 and 2004 deficits as manageable. From the viewpoint of financial markets, “record deficits” shouldn’t be a big deal, at least if the experiences of the 1980s and 1990s are a guide.

The message from Washington to Wall Street last week may as well have been: “Yo, bond owners -- take a chill pill.”

There are plenty of economists who have long argued that there is no direct correlation between federal borrowing and trends in interest rates.

“I have believed ever since 1981 that budget deficits have no impact on interest rates, and by inference no direct impact on financial markets in general,” said Scott Grannis, economist at Western Asset Management in Pasadena.

Deficits must be considered in relative terms. Relative to the size of the economy -- or gross domestic product -- the 1983 deficit was the high point, at 6% of GDP that year.

By contrast, the 2003 and 2004 deficits, as estimated by the White House, would amount to 4.2% of GDP each year, or nearly one-third less than in 1983.

The administration, and many analysts, also defend the current deficits as crucial to the economy’s revival. Keynesian economics dictate that the federal government takes the lead when growth is subpar, borrowing if necessary to provide a jump-start for activity.

That was the Bush administration’s rationale for the tax cut Congress approved in May. This year’s borrowing wave will in part pay for that cut, in addition to reflecting the cost of the war in Iraq and its aftermath.

Whatever the justification for big budget deficits, many Americans understand that running up the national debt isn’t a cost-free undertaking. There is an annual interest cost that potentially takes money away from federal spending on other things (expanded Medicare benefits, national parks, social services, etc.). There also is the long-term cost of repaying the debt, which will be borne by future generations.

Yet in recent public opinion polls the deficit hasn’t ranked very high on the worries list.

A Gallup Poll in mid-June asked 1,006 Americans to name “the most important problem facing this country today.” The economy was No. 1, listed by 30% of respondents. The federal budget/federal debt was named by just 3%, tied for 11th on the list and below such concerns as terrorism, fear of war and the decline of morals.

For bond owners, however, the latest deficit estimates can’t be comforting, even if they aren’t yet overly worrisome.

There are some important differences between the last periods of rising deficits and the current period.

Bond yields fell in the mid-1980s and early 1990s even as the deficit swelled, but that was because the Federal Reserve was aggressively cutting short-term interest rates both times.

“If the Fed has the monetary floodgates open, deficits have less of an effect on interest rates,” said Paul Kasriel, economist at Northern Trust in Chicago.

This time around, unless the economy weakens further, the Fed would appear to be done easing credit, though it also is expected to keep short rates where they are indefinitely.

Greenspan last week said the central bank could cut rates further, but he also suggested there might not be a reason to do so.

What’s more, long-term bond yields arguably had nowhere to go but down in the mid-1980s and early 1990s, as inflation declined from high levels. Inflation eats away at fixed-income returns, so it’s the major consideration for investors in determining what kind of yields they’ll accept.

This time, the talk of the last few months has been that the nation might be on the verge of outright deflation -- essentially, negative inflation. If that’s what the future holds, it’s conceivable that long-term bond yields could go back into a steep decline.

But bond owners also must consider the possibility that deflation fears have been overblown, and that inflation might be stabilizing at low levels or even poised to rise somewhat, should the economy accelerate.

In that kind of environment, long-term interest rates might feel upward pressure that could be worsened by a heavy new wave of Treasury borrowing, depending on how much credit other sectors of the economy -- state and local governments, companies and individuals -- would be demanding.

There’s another consideration that may loom larger than ever, some analysts say: the willingness of foreign investors to buy U.S. securities. They now own about 32% of Treasury debt.

As is often reported, the United States can run budget and trade deficits because the rest of the world is a willing creditor. If that were to change for whatever reason -- if foreign investors balked at extending America credit in large amounts -- one effect could be to drive U.S. interest rates up.

All of these worries are hypothetical, of course. But bond investors can be forgiven if they are suddenly much more concerned with the hypothetical. If you’re lending money to someone for five or 10 years at a fixed rate, it’s imperative to ask not just what might go right, but also what might go wrong.

Tom Petruno can be reached at tom.petruno@latimes.com.