Bond Yields Don't Have to Follow the Deficit Higher

With last week's release of the federal budget showing an increasing deficit, I've received numerous emails from readers who are worried about whether bond yields are about to head up as a result. Their concerns are being fueled by news reports that make it seem as if bond yields will surely follow Treasury borrowing on its northward path.

However, history shows that bond yields and deficits are not necessarily correlated over time. Sometimes yields do move along with deficits, but they can also move in the opposite direction.

Changes in deficits matter most to yields when they're unexpected. Much of the impact, though, tends to be short-lived, and it primarily affects bond traders. When I managed money market funds, I used to watch Treasury settlements closely because they can pressure the fed funds rate up or down a few basis points. When I was managing bond portfolios, I kept an eye on Treasury auction schedules because they could provide good entry or exit points for nimble traders and can strongly influence the shape of the yield curve.

Related Stories

Looking at Bond Funds Through a Bond Manager's Eyes

An example of this is my concern that borrowing in the two-year area may exceed expectations in the next few months. If so, surprised traders may push the two-year's yield up to the point where I'd have an interest in it (about 20 to 30 basis points higher). Another example is the little kick that bond prices got last week when it was announced that the stimulus plan was dead.

The Long View

While this analysis can be useful from a trading perspective, it becomes less meaningful from an investment perspective. The longer-term viewpoint in the chart below looks at the rolling four-quarter change in Treasury borrowing (on the left scale) vs. the yield on the 10-year Treasury. I've estimated quarterly borrowing through next September to correspond with the White House Office of Management and Budget's latest yearly estimate.

Bond Yields vs. Budget The two don't always move in tandem

Source: Federal Reserve

This chart shows a general rise in borrowing from the mid-'60s through the early '80s, along with a general rise in bond yields. However, bond yields declined sharply from then through the early '90s, while the deficit hovered in a trading range and then hit new highs. After the deficit peaked in 1992 and then swung to a surplus, the rate of decline in bond yields slowed.

If we examine some defined periods closely, we can see several things:

From the third quarter of 1974 to the first quarter of 1976, Treasury borrowing went from $8 billion to what was then an astounding $90 billion. During that time, the 10-year yield fell from 8.04% to 7.73%. By the end of 1976, the deficit was a still-high $69 billion, but yields had fallen to 6.87%

From the end of 1979 to the third quarter of 1981, the deficit ran from $37 billion up to $76 billion. Bond yields followed, rising from 10.39% to 15.32%. The deficit continued to soar, ballooning to $223 billion by mid-1983. Bonds reversed course, however, falling to 10.85%.

The deficit then fell to $162.5 billion by the middle of 1984. However, bond yields rose to 13.56%.

From mid-1984 to the end of 1985, borrowing picked back up to $222.5 billion. Bond yields moved in the opposite fashion again, falling to 9.26%. By the end of the first quarter of 1987, the deficit had fallen modestly to $205 billion. Bonds fell by a much greater amount to 7.25%.

The deficit continued falling to $141 billion by mid-1988, while bonds zigzagged up to 8.92%.

From mid-1989 through the second quarter of 1992, borrowing went from $125 billion to a record $340 billion. Yet the yield on the 10-year declined from 8.28% to 7.26%.

Most recently, expectations since early September have gone from a surplus of $150 billion to a deficit of $100 billion. The 10-year's yield stands only about 20 basis points higher than it did Sept. 10.

Examining the Variables

So bond yields have deviated significantly from budget trends in the past. This doesn't mean that budgets are unimportant; there has occasionally been a correlation. Budgets, though, are just one of many variables that go into setting bond prices. Other variables include the dollar, monetary policy, the interaction of supply and demand, current and expected inflation, and the extent to which government borrowing crowds out the private sector.

Contrary to many opinions I see in the media, bond yields don't have to rise just because the deficit does. That's important because I believe that if bond yields were to rise, the economy would have an even harder time accelerating than it has now. A rise in bond yields could also present a valuation challenge to stocks.

So if you're an equity holder, you should hope for a repeat of those times when bond yields moved counter to the deficit. That could be what both the economy and the stock market need.

---

Brian Reynolds is a Chartered Financial Analyst who spent more than 16 years as a fixed-income portfolio manager and economist at David L. Babson & Co. in Cambridge, Mass. He currently writes and lectures about investment issues and trades for his own account. At the time of publication, he had no positions in any of the securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell. He welcomes feedback at Brian Reynolds.