The Deficit and Your Portfolio

I don't think there's any way to settle this argument in the abstract now, and I'm not even sure that the data will be clear enough to declare a winner. After all, none of the parties to the great supply-side experiments of the Reagan administration is willing to admit defeat 20 years after the numbers are in.

What Investors Can Take Away

But using my three-part framework, investors should be able to calculate how much play there is in the system and how much (or little) time there is before truly negative consequences start to appear.

Interest rates go up under all of these scenarios. Even the Bush budget sees rates on the 10-year Treasury note climbing to 5.6% in 2008 from less than 4% now. If the deficit turns out to be worse than currently projected, or if it comes to be seen as structural rather than cyclical, investors can expect interest rates that are higher than that projection.

We're likely to know the answer to the cyclical/structural debate some time in calendar 2004 or so. If the economy does indeed start to pick up -- which in itself will put some upward pressure on interest rates -- but the actual and projected deficit stubbornly won't fall significantly, then investors here and abroad will start to rethink their bets on the U.S. dollar and the assets denominated in dollars.

And that, too, could easily push interest rates above the 5.6% projected by the White House for fiscal 2008.

Exactly how high rates could climb and how fast depends on far more than just the size of the federal budget deficit. But reading the numbers from Washington, investors should plan on an end to 20 years of falling interest rates and building portfolios with climbing rates, even if they are just gently climbing.

Picking the right asset classes for the new investing environment is the topic of my next column. In that piece, I'll take a look at asset classes that most investors don't own but that should now be part of every investor's portfolio planning.