The political wrangling over President Barack Obama's 2010 budget proposal has begun. Republicans think the document is social engineering, and many Democrats object to cuts in favored programs. Perhaps more important, there is also plenty of debate over the budget's impact on the federal deficit. The Administration's numbers show the recession and massive fiscal stimulus will swell the gap to 12.3% of gross domestic product in fiscal 2009, from 3.2% in 2008, but the red ink will be cut in half by 2011 to 5.9%, and to a more manageable 3% in 2013 and beyond.
Much depends, however, on whether you believe, as the budget blueprint assumes, that the economy will shrink only 1.2% this year and then grow 3.2% in 2010 and more than 4% annually over the following three years. Most private economists think that scenario is a stretch. The recession will be deeper, they say, and the recovery more muted.
What's not a stretch is the massive borrowing the Treasury will have to do over the next couple of years to make up for lost revenue and to pay for the stimulus package and other financial-sector relief. The budget projects new federal borrowing of $2.56 trillion in fiscal 2009, followed by $1.14 trillion more in 2010. Most economists think these projections are on the low side, especially next year's, which depends on a solid economic recovery to cut the deficit to 8% of GDP. Even if the numbers are on target, Treasury's demands on private sector funding will balloon to $9.5 trillion in 2010, or 65% of GDP, double the level required in 2007.
The question: Can the markets digest this enormous amount of new paper without pushing up interest rates on longer-term securities or crowding out private sector borrowing, as investors choose the relative safety of Treasury notes over corporate bonds? If this flood of new supply hits the bond market amid insufficient demand, bond prices will fall, driving their yields higher in order to attract buyers. The yield on 10-year Treasuries has risen from 2.1% two months ago to 3% on Mar. 4, a factor that has kept fixed-mortgage rates higher than they would be otherwise.
In the current economic climate, however, the Administration should be able to finance its stimulus efforts with little difficulty. That's because Treasury rates turn on two things: investors' expectations of inflation and their appetite for risk. Few economists think inflation, which can erode returns on fixed-income securities, will be a problem anytime soon. Deflation is more of a concern right now.
Both at home and abroad, investors are flocking to the safety of Treasuries. During the final week of February, the U.S. auctioned a record $94 billion in securities with maturities from two to seven years, and buying was robust. The $22 billion in seven-year notes drew more than twice as many bids as those accepted.
Foreign demand is especially strong. The Treasury's latest international capital report shows net foreign purchases of Treasuries totaled $772 billion in 2008, the most since records began in 1977. At the same time, sharply increased saving by U.S. consumers is adding greatly to the pool of private sector savings that the Treasury can tap.
Some of the recent rise in bond yields may reflect market disappointment over the Federal Reserve's failure to follow through with its idea to buy Treasuries as a way to lower interest rates broadly. From July through January, the supply of government securities hitting the market rose by nearly $1 trillion, but yields across the maturity spectrum remain below their July levels. If demand for Treasuries begins to lag behind new offerings, the Fed could still jump in as a buyer.
Further down the recovery road, longer-term government yields are sure to rise, perhaps significantly. As inflation concerns reemerge, and as investors become more willing to take on risk, they will eschew the safety of Treasuries for other investments. But until then, there should be plenty of U.S. and foreign investors willing to finance Washington's plans.