Obama Clashes With Yield Shows Bonds Below Growth Outlook
As President Barack Obama starts his second term, the bond market is already telling him that the administration’s forecasts for economic growth over the next four years are too optimistic.
The Office of Management and Budget predicts yields on 10- year Treasury notes will rise to average 4.1 percent in 2015 and 4.9 percent in 2017 as the economy expands at about a 4 percent rate in the second half of Obama’s term. Bond prices suggest the yield, now at about 2 percent, will average below 3 percent two years from now, implying that gross domestic product will fall short of OMB projections, according to data compiled by Bloomberg.
While Obama’s legacy may depend on a recovering economy, the bond market is signaling GDP may not in the next few years exceed the 3.3 percent annual average of the decade preceding the financial crisis and tax revenues will fall short of what the president needs to close the budget gap. That’s not all bad news because Treasury borrowing costs just above last year’s record lows mean easy credit for consumers and companies as well as sustained demand for riskier assets such as stocks.
“Clearly, the bond market is on one end of the spectrum and these guys are on the other end, believing rates are going to go up so fast,” Priya Misra, the head of U.S. rates strategy at Bank of America Merrill Lynch in New York, one of the 21 primary dealers that trade with the Federal Reserve, said Feb. 8 in a telephone interview.
“The 10-year yield rising to about 5 percent in four years is too optimistic,” Misra said. “Maybe you could argue that rates are a little depressed now, given inflows into bond funds and the Federal Reserve’s debt purchases, but this is nothing like a normal recovery.”
Market expectations reflected in bond yields are consistent with the median estimate of 84 economists in a Bloomberg survey who say the U.S. will grow 2.7 percent in 2014. The OMB forecasts 3.5 percent next year.
The clashing views come after the 10-year note yield fell as low as 1.38 percent in July and averaged 1.79 percent in 2012, the lowest since the debt was first issued in 1953. The next threat to Obama’s forecast is looming as Congress faces a March 1 deadline to avert spending reductions of $1.2 trillion over nine years that may cut growth in 2013 by half, according to the non-partisan Congressional Budget Office.
Colin Kim, director of the Treasury’s Office of Debt Management, noted the divergence between the market outlook and his agency’s assumptions during the government’s regular quarterly meeting with the Treasury Borrowing Advisory Committee on Feb. 5, according to minutes posted on the Treasury Department’s website.
The gap between rates implied in the future by the so- called yield curve of actively traded securities and the administration’s forecasts may be narrower than just looking at the raw numbers suggests. Demand for government bonds has been elevated by Federal Reserve purchases and new rules requiring banks to buy the safest assets for their reserves, which have depressed the compensation investors demanded for holding longer-term debt.
The Fed has bought more than $2.3 trillion of Treasuries and other securities since 2008, and plans to continue purchasing a combined $85 billion of government and mortgage debt a month to pump money into the financial system. Deposits at U.S. banks exceed loans by $2 trillion, with much of the surplus used to buy Treasuries. Bank holdings of Treasuries increased 15 percent to $521.3 billion in the past year.
While slower growth would make it harder for Obama to meet his deficit goals, yields below the administration forecast would limit government debt-service costs. Interest on the $16 trillion debt has fallen as Treasury yields stayed about record lows. The U.S. spent $359.8 billion on financing expense in fiscal 2012, down from $454.4 billion in 2011.
Yields on 10-year notes rose five basis points, or 0.05 percentage point, to 2 percent last week, according to Bloomberg Bond Trader data. The benchmark 2 percent note maturing in February 2023, sold Feb. 13, finished the week at 99 31/32. The yield was unchanged at 12:34 p.m. in New York.
Treasuries lost 1.1 percent in January, the worst start to a year since 2009, according to Bank of America Merrill Lynch bond indexes. The yield on the benchmark 10-year note has risen 25 basis points from 1.76 percent at the end of last year.
Fed debt purchases have pushed corporate and consumer borrowing rates down. Yields on investment-grade corporate bonds dropped to a record low 2.73 percent on Nov. 8, compared with the 10-year average of 5.02 percent, according to Bank of America Merrill Lynch bond indexes. Freddie Mac said last week rates on 30-year mortgages averaged 3.53 percent, down from 6.74 percent in 2007.
Yields on 10-year notes are forecast to climb to 2.25 percent by the end of the year, according to the median estimate of 65 respondents in a Bloomberg News survey. The last time rates were above 4.9 percent, the average for 2017 anticipated by the Office of Management and Budget, was in July 2007 as the financial crisis was mounting.
Obama said in his Feb. 12 State of the Union address that even though the labor market is improving, more needs to be done to create jobs. He proposed raising the federal minimum wage to $9 an hour from $7.25 by 2015 and spending $50 billion on urgent infrastructure projects.
“What we’ve seen over the last couple of years from both the Federal Reserve and the fiscal authorities is that they are overly optimistic on their growth expectations,” Guy LeBas, the chief fixed-income strategist at Janney Montgomery Scott LLC in Philadelphia, said in a telephone interview on Feb. 14.
“The sources of higher interest yields include higher economic growth, increasing inflation expectations and reduced Fed demand. While one of those three might come into play in 2013 or 2014, it is very unlikely that all three do,” said LeBas, who predicts the 10-year note yield will end the year at about 2.2 percent.
Average weekly earnings adjusted for inflation showed no gain in 2012, and the unemployment rate in January rose to 7.9 percent from 7.8 percent the month before. The economy unexpectedly shrank by 0.1 percent in the fourth quarter.
For the three years following the recession that ended in June 2009, the jobless rate averaged 9.2 percent and growth after accounting for inflation averaged 2.3 percent, Robert Pollin, a professor of economics and co-director of the Political Economy Research Institute at the University of Massachusetts at Amherst, said in a telephone interview on Feb. 12. That compares to average unemployment of 6.3 percent and real GDP expansion of 4.5 percent for the three-year periods following the end of the previous eight recessions.
“You’ve got strong headwinds every way you look working against returning to the kind of economic growth levels we saw pre-2007,” Alan Wilde, head of fixed-income and currencies in London at Baring Asset Management, which oversees $53 billion, said in a telephone interview on Feb. 12.
“The idea that bond yields could return to 4 percent to 5 percent, with a nominal growth rate compatible with stable employment, is still some way off,” he said. “I subscribe to the gently rising scheme of things for Treasury yields rather than a rapid burst higher.”
Implied yields may be below Congressional Budget Office estimates in part because the so-called term premium required by investors to hold longer-maturity debt has remained around record lows, and negative since 2011, amid Fed purchases. A negative term premium means investors are not requiring any excess return to hold long-term debt instead of rolling over a series of short-term securities as they mature.
“We can’t take market implied forward rates today at face value due to the Fed’s quantitative easing,” Zach Pandl, an interest-rate strategist in Minneapolis at Columbia Management Investment Advisers LLC, which oversees $340 billion said in a telephone interview on Feb. 15. These rates “are related to expectations about where the economy and monetary policy is going, but central banks are deliberately distorting those rates to stimulate recovery.”
The premium was minus 0.62 percent last week, up from a record low of minus 1.0187 percent on July 24. It averaged 0.916 percent in the decade before the start of the financial crisis in 2007.
Even if growth doesn’t meet Obama’s forecasts, rising home and car sales show the economy is improving, according to James Smith, chief economist at Parsec Financial in Asheville, North Carolina. His forecast for a 10-year Treasury yield of 4.11 percent at the end of 2013 is the highest in a survey of 64 participants by Bloomberg News.
“The flight-to-quality demand and Fed purchases has helped keep yields below the historic 100-year average of about 3 percentage points over the inflation rate,” Smith, an economist at the Fed in Washington from 1975 to 1977, said in a telephone interview Feb. 14. “But the Fed buying won’t last forever and the economy is back to looking more like a typical expansion,” he said. “Market expectations always turn on a dime and nobody sees it coming.”
U.S. auto sales per dealership probably will rise to a record in 2013, according to Urban Science, a Detroit-based consulting firm. U.S. light-vehicle sales have climbed by at least 10 percent each of the last three years, including a 13 percent increase last year that was the biggest since 1984.
Purchases of new U.S. homes reached 367,000 in 2012, the most since 2009 and the first annual gain in seven years.
The Congressional Budget Office assumes the 10-year Treasury yield will average 5 percent in 2017 with real GDP growing more than 4 percent in each of the two prior years, according to its long-term budget and economic outlook report published Feb. 5. Accelerating growth will help boost revenues and narrow the U.S. deficit-to-GDP ratio to 2.4 percent by 2015.
The budget deficit will decrease to $845 billion, the least since 2008, or 5.3 percent of GDP, for the current fiscal year, ending September 30, the report said. In fiscal 2012 the deficit amounted to 7 percent of total U.S. output.
Obama called on Congress last week to pass spending reductions and close tax loopholes to delay the budget cuts, known as sequestration, set to begin next month. Republicans have said they won’t consider raising revenue beyond the $650 billion tax increase on top earners the president won as part of the budget deal enacted on Jan. 2.
The sequestration cuts “won’t help the economy, won’t create jobs, and will visit hardship on a whole lot of people,” Obama said today at the White House. “The whole design of these arbitrary cuts was to make them so unattractive and unappealing that Democrats and Republicans would actually get together and find a good compromise of sensible cuts as well as closing tax loopholes and so forth.”
Lawmakers agreed to the automatic spending cuts, to be spread over nine years, as part of a 2011 fiscal deal to raise the U.S. debt limit. The reductions were supposed to be so onerous that Congress and the president would never let them occur and would find a plan to replace them.
“We seem to be a long way away from 4 percent real growth,” David Brownlee, the head of fixed-income at Sentinel Asset Management, which oversees more than $18 billion, said in a Feb. 13 telephone interview from Montpelier, Vermont. “It’s just really preliminary to think rates can go up that high.”
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