Deficit Outlook Taken in Stride

Few people would disagree that the federal government must foot a huge chunk of the tab for rebuilding the Gulf Coast after hurricanes Katrina and Rita.

But House and Senate fiscal conservatives say that expense should be offset elsewhere in the budget -- not placed on the national credit card (i.e., by running up the deficit).

Twenty years ago Wall Street would have concurred, and vociferously. There would have been stern jawboning from investors who were large owners of Treasury bonds, warning that they wouldn’t stand for another wave of massive government borrowing and spending that could stoke inflation. Don’t try it, they’d admonish, or surely they and other investors would push up long-term interest rates in the marketplace, forcing Uncle Sam to pay a steep price for being profligate.

Today, however, the bond market is no ally of fiscal conservatives in Congress. Just the opposite: With rates on long-term Treasury bonds not much above their generational lows reached in mid-2003, investors are practically inviting the government to borrow more.

And that seems likely as the bills from Katrina and Rita roll in. There is no consensus on Capitol Hill for significant spending reductions or for tax increases, even as Katrina alone could mean some $200 billion in additional federal expenditures over time, by some estimates.

The public, in a recent CNN opinion poll, heavily favored cutting spending in Iraq to pay for hurricane recovery. But the White House appears unwilling to go along with that idea.

Facing the prospect of a ballooning deficit, Sen. Judd Gregg (R-N.H.) publicly lamented that “there’s been a working majority for disregarding fiscal discipline.” He was talking about Congress, but he might as well have meant financial markets.

Last week brought yet another reminder of what a serene place the bond market has become.

The Federal Reserve on Tuesday boosted its key short-term interest rate from 3.5% to 3.75%, the 11th quarter-point increase since mid-2004. The central bank also indicated it wasn’t finished tightening credit.

Historically when the Fed is in the midst of a rate-raising campaign, the bond market is wary at the least; longer-term rates often rise in tandem, especially when Fed officials make clear that they’re worried about inflation pressures. Inflation is the great enemy of bond holders because it erodes fixed returns.

The consumer price index rose at a 3.9% annualized rate from January through August, compared with a 3.3% rise for all of 2004. Energy was the prime culprit behind the increase, of course. “Higher energy and other costs have the potential to add to inflation pressures,” the Fed said in its post-meeting statement.

What’s more, policymakers made a notable change in a line they’ve been using all year. They had been saying that “longer-term inflation expectations remain well-contained.” This time they referred to those expectations merely as “contained.” Economists took note because they figure there’s a message in every tweak to the Fed’s wording.

What was the Treasury bond market’s response to higher short-term interest rates and to the Fed’s apparent heightened concern about inflation? Mostly yawns. The yield on the 10-year Treasury note, a benchmark for mortgage rates, was unchanged on Tuesday and ended the week where it started, at 4.25%.

That’s also just about where the T-note yield was at the start of the year. And it’s actually down from 4.65% in May 2004, just before the Fed began to lift short-term rates.

Note also that a bond paying 4.25% in annual interest would lose nearly all of that to inflation at the current annualized pace of price increases.

The best explanation most analysts have for the Treasury bond market’s lack of concern about the upward trends in short-term rates and inflation is that investors don’t expect either to last much longer.

Indeed, in the wake of Katrina and Rita, many Wall Street pros are betting that the economy will slow. That, in turn, could weaken demand for energy, putting downward pressure on elevated oil and natural gas prices.

And soon enough, according to this view, Fed policymakers will call it quits, figuring they’ve done enough to tighten credit.

David Rosenberg, an economist at brokerage Merrill Lynch & Co. in New York, has been insisting all year that a slowdown is imminent. History shows, he says, that when the Fed is raising rates against the backdrop of surging energy prices and a weak stock market, the outcome is nearly always a marked deceleration of the economy.

If that’s your outlook, why worry whether the government has to borrow a few hundreds of billions more?

Besides, deficits are relative. The 2004 budget deficit was $412 billion, a record in dollar terms. But it amounted to 3.6% of the U.S. economy overall as measured by gross domestic product. By contrast, the 1983 deficit was 6% of GDP; the 1992 deficit was 4.7% of GDP.

It’s not surprising bond investors would have been more nervous about red ink in the 1980s and early ‘90s; it was consuming more of the economic pie.

There’s another popular explanation for why investors are so willing to accept arguably paltry yields on long-term bonds, despite the inherent risks: Around the globe, there’s a lot of money looking for a home, and not enough compelling ideas.

Government bond yields have been falling since mid-2004 in Germany, France, Britain, Mexico and Australia, among other countries besides the U.S.

This is a new world, some say -- a highly competitive world in which money and goods flow freely. That’s a recipe not for inflation in the long run, but for disinflation or outright deflation, one argument goes. If that’s going to be our reality, locking in a government-guaranteed 4.25% annual yield for 10 years might well turn out to be a smart investment decision.

Bond investors “feel very confident that inflation is not going to be a problem over a long period of time,” said William Prophet, interest rate strategist at investment firm UBS Securities in Stamford, Conn.

Yet as U.S. bond yields stay low, what’s also low is the margin for error in owning bonds. What if energy costs, and inflation, don’t come down soon? What if the economy faces other Katrina-like shocks that require even heavier new borrowing? What if foreigners gradually lose their appetite for U.S. securities and for funding our deficits?

Bill Dudley, chief U.S. economist at brokerage Goldman Sachs & Co. in New York, said that the bond market probably figures it can easily absorb additional deficit spending for Katrina and Rita.

“But on another level, it’s quite disturbing in two ways,” he said. “First, do we never have to pay for anything?” Second, he said, the nation is rapidly accumulating heavy new debts “as the entitlement spending wave approaches” -- meaning the baby boomer retirement wave.

“Not a good strategy,” Dudley offers.

So far, however, bond investors who have worried about these risks have simply been worrying too much. If long-term interest rates were to soar, anyone owning bonds at current fixed yields would see the value of their securities plunge. But until then they’re collecting a yield that is better than what they could earn on shorter-term cash accounts. Why rock the boat?

Increasingly, much more is riding on continued low bond yields than just the happiness of the investors who own fixed-income securities.

The U.S. housing market is addicted to low long-term interest rates. Homeowners who are deep in debt, and facing higher payments on adjustable-rate mortgages in the next few years, are counting on cheap fixed-rate loans to bail them out. They certainly don’t want the bond market to object to a new boom in Treasury borrowing.

President Bush’s tax cuts on capital gains and dividend income, enacted in 2003, also may depend on the bond market’s good graces. The cuts are due to expire at the end of 2008. If long-term interest rates were to shoot up, the pressure on Congress to pare the budget deficit could doom Bush’s plan to extend those tax breaks.

With the easier choice to just let the budget deficit balloon, congressional veterans must marvel at how far we’ve come from the days when James Carville, a political advisor to President Clinton, described how the bond market demanded, and policed, fiscal responsibility in Washington.

“I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter,” Carville said. “But now I want to come back as the bond market. You can intimidate everybody.”

Not anymore.

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