US Fiscal Deficit, Imbalances

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US Fiscal Deficit, Imbalances Bond Yields
Myopia or Special Circumstances?

• Lisa Kaess
• ATRIUM advisors
• Biarritz Group Annual Meeting July 2005
• Vancouver, B.C. - Canada

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Some initial thoughts on a complex subject -

• The bond market conundrum and indifference to
  deterioration in US fiscal (and current account)
  position.
• Studies (limited) words of wisdom
• US Fiscal Outlook
• Considerations
• Increased supply of securities
• Broader sources of demand
• Special circumstances or a matter of time?
• Special Thanks Michael P. Carey, Calyon
  Corporate Investment Bank

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A Fine Mess Weve Gotten Ourselves Into
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US Budget Treasury Yields Counter Intuitive
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What the experts say

• In the United States there appears to have been
  little correlation between deficits and debt and
  inflation.
• John Taylor, Monetary Policy Implications of
  Greater Fiscal Discipline,
• (1995 Federal Reserve Symposium, Jackson
  Hole,WY)
• Large deficits and public debt are likely to
  have raised real interest rates by fiscal
  crowding out and reduced investment and output
  growth Econometric evidence at the OECD and IMF
  implies that the bulk of the real interest rate
  increases in recent years reflects fiscal
  crowding out.
• Kumiharu Shigehara, OECD, 1995 (Jackson Hole,
  WY)
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  

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The bond market conundrum Alan Blinders
Views (from 9/04 presentation)

• Why is the bond rate 4?
• Three Hypotheses
• Inflationary Expectations have fallen.
• The Fed is nearing the end of its tightening
  cycle.
• The markets growth expectations are lower than
  the Feds.
• NOTE An historically average yield curve rises
  less than 100 bps between Funds and the 10-yr
  bond. Thus the bond at neutral may be about 5.

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Recent TIPS auction results

• Recent Treasury Note and Bond Auction Results
• Security Issued Maturity Interest Rate Yield
  Price Per 100
• 5 Year 7-15-05 7-15-10 3.875 3.970 99.572992
• 10 Year 7-15-05 7-15-15 1.875 1.939 99.420765
• 2 Year 6-30-05 6-30-07 3.625 3.650 99.952201
• 5 Year 6-15-05 6-15-10 3.625 3.705 99.637908
• 2 Year 5-31-05 5-31-07 3.500 3.615 99.7890029
• 3 Year 5-16-05 5-15-07 3.750 3.821 99.800526
• 5 Year 5-16-05 5-15-07 3.875 3.890 99.932269
• 10 Year 5-16-05 5-15-07 4.125 4.220 99.231425

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Are there other issues that need to be taken into
consideration?

• Supply issues
• Near term outlook
• Alternative investments
• Demand issues
• Baby boomer retirement
• Central Bank purchases
• Savings Glut Economist article on JPM study

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Can deficit reduction be sustained long term?
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Strong Tax Receipts Reduce 2005 Budget Gap
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TIPS Have they helped buffer the impact of
fiscal deficits?
Source US Treasury / Haver Analytics
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Asset price inflation? Housing Bubble? Or simply
Signs of froth in some local markets - Alan
Greenspan, 20 July 2005
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US Housing Conditions A closer view
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Demand Side Central Bank Purchases
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Myopia or a question of time?

• US Off-balance Sheet Liabilities Include
• Iraq War
• New prescription drug benefits for seniors
• Unfunded Liabilities at State/Local Level
• Currently on a pay as you go basis
• Government Accounting Standards Board new rules
  for 84,000 state and local entities
• As of Dec 2006 will have to note annual
  contribution to fund long term liabilities
  (mainly health) for the next 30 years.
• Mercer Consulting estimates could run 40-60 times
  current health care. Example California
  retirees health benefits 2005-06 895mm vs.
  liability of 36 bn.
• Will concerns about housing, external balances
  escalate?

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Some final thoughts

• For major countries, smaller direct impact of
  fiscal imbalances, and hard to measure.
• Special Circumstances have impacted markets in
  recent years, both on supply and demand side.
• Nevertheless some time bombs do exist.
• Markets unlikely to care until they begin to show
  up.
• Timing? 2007 perhaps late 2006.