As President Obama starts his second term, the bond market is telling him that his administration’s forecasts for how fast the economy will grow are too optimistic. The Office of Management and Budget predicts yields on 10-year Treasury notes will rise to an average of 4.1 percent in 2015 and 4.9 percent in 2017 as the economy expands at about a 4 percent rate.
Yet government officials know the OMB’s projections are not universally accepted. Colin Kim, director of the Treasury’s Office of Debt Management, noted the divergence between the market outlook for the next four years and the government’s assumptions during the OMB’s quarterly meeting with the Treasury Borrowing Advisory Committee on Feb. 5, according to the Treasury website.
Traders in the bond market, using a common formula that extrapolates future yields from current bond prices, are signaling that the yield on 10-year Treasuries, about 2 percent today, will still be below 3 percent two years from now. (When bond prices fall, yields rise. Inflation and fast economic growth generally drive up yields, and slow growth keeps yields low.) Separately, a panel of economists surveyed by Bloomberg News produced a median forecast of only 3 percent GDP growth in 2015.
If the market is correct, growth won’t exceed the 3.3 percent annual average that prevailed in the decade before the financial crisis. In this scenario, tax revenue may fall short of what’s needed to close the budget gap. “The 10-year yield rising to about 5 percent in four years is too optimistic,” says Priya Misra, the head of U.S. rates strategy at Bank of America Merrill Lynch. “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.”
Demand for government bonds is up because of Federal Reserve purchases and new rules requiring banks to increase their holdings of the safest assets. As part of its quantitative easing, the Fed has bought more than $2.3 trillion of Treasuries and other securities since 2008, and is now buying $85 billion of government and mortgage debt every month to pump money into the financial system. Deposits at U.S. banks exceed loans by $2 trillion, with much of the surplus going into Treasuries.
Slower growth would make it harder for Obama to meet his deficit goals, but yields below the administration forecast would limit government debt-service costs. Interest paid on the $16.4 trillion national debt has fallen as Treasury yields stayed near record lows. The U.S. spent $359.8 billion on financing expenses in fiscal 2012, down from $454.4 billion in 2011.
The Fed’s huge debt purchases have pushed down corporate and consumer borrowing rates. Yields on investment-grade corporate bonds dropped to a record low of 2.73 percent on Nov. 8, compared with the 10-year average of 5.02 percent, according to Bank of America Merrill Lynch. Freddie Mac said recently that rates on 30-year mortgages averaged 3.53 percent, down from 6.74 percent in 2007. “What we’ve seen over the last couple of years from the Federal Reserve and the fiscal authorities is that they are overly optimistic on their growth expectations,” says Guy LeBas, chief fixed-income strategist at Janney Montgomery Scott. “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 will.”
Although the U.S. pulled out of its worst downturn since the Great Depression during Obama’s first term, unemployment has remained higher than the average of 6.8 percent over the past 10 years. 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 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. I subscribe to the gently rising scheme of things for Treasury yields rather than a rapid burst higher,” says Alan Wilde, head of fixed income and currency at Baring Asset Management. “You’ve got strong head winds working against returning to the growth levels we saw pre-2007.”