Treasury Sales May Rise 50 Percent as Deficit Suddenly Swells

By Elizabeth Stanton

Oct. 15 (Bloomberg) -- Sales of Treasuries may increase for the first time since 2004 as the U.S. federal budget deficit expands, jeopardizing the biggest bond rally in five years.

Government auctions of bills, notes and bonds in the fiscal year that started this month may rise more than 50 percent to $220 billion, according to UBS Securities LLC, one of the 21 primary dealers that underwrite Treasury auctions. The first decline in corporate tax revenue since 2003 increased the shortfall by 12 percent to $162.8 billion for the year ended in September, from $144.8 billion in the 12 months through April.

With the Federal Reserve cutting interest rates to keep the economy from falling into recession and inflation slowing, an increase in net sales would mar an otherwise bullish outlook for U.S. government debt, which has returned 4.3 percent this year, Merrill Lynch & Co. index data show. Less than six months ago, Treasury officials credited a shrinking deficit for allowing them to eliminate sales of three-year notes.

``Unless the economy turns on a dime and starts to show strength again, we're going to be looking at increased Treasury issuance beginning with bills later this year and spreading out across all Treasuries beginning in the first quarter,'' said William O'Donnell, head of U.S. government bond strategy at Zurich-based UBS AG's securities unit in Stamford, Connecticut.

UBS, whose economists are ranked the best on Wall Street in the latest poll by Institutional Investor magazine, forecasts a $225 billion deficit in fiscal 2008.

Deficit Forecasts

The difference for fiscal 2007 was the smallest in five years as tax revenue increased and spending rose at the slowest pace of George W. Bush's presidency.

The improvement may be short-lived. The average estimate of UBS, Barclays Capital Inc., Banc of America Securities LLC, RBS Greenwich Capital Markets Inc. and Wrightson ICAP is for the shortfall to widen to $196 billion this fiscal year. All are primary dealers, except Wrightson, a Jersey City, New Jersey- based research firm specializing in Treasury finance.

The Concord Coalition, an Arlington, Virginia-based nonpartisan group that advocates a balanced budget, said it expects the deficit will continue to grow, exceeding $500 billion by 2013, if tax cuts slated to expire in 2010 are extended and spending increases at its historical rate.

``All else being equal, greater supply should lead to higher yields,'' said Michael Pond, an interest-rate strategist in New York at Barclays, the securities unit of London-based Barclays Plc. The firm anticipates spending to exceed revenue by $200 billion this year.

`Higher Yields'

Selling Treasuries is the government's main way of funding the gap. The yield on the benchmark 10-year note due in 2017 rose 5 basis points, or 0.05 percentage point, to 4.68 percent last week, according to bond broker Cantor Fitzgerald LP in New York. The price of the 4 3/4 percent security due in August 2017 fell 11/32, or $3.44 per $1,000 face amount, to 100 16/32.

A National Bureau of Economic Research study in 2005 found that a 1 percentage point increase in the deficit as a share of gross domestic product, lasting for three years, adds 0.40 percentage point to 0.50 percentage point to 10-year note yields.

The deficit shrank to 1.1 percent of GDP in April and widened to 1.2 percent in September, according to Louis Crandall, the chief economist at Wrightson. The midpoint of Crandall's forecasts for fiscal 2008 is $200 billion, or 1.4 percent of estimated GDP over the period.

``With that framework they will probably need to raise note sizes for the first time in some years by the end of the fiscal year,'' Crandall said.

Reduced Sales

The government reduced sales of Treasury securities to about $142 billion in fiscal 2007 from a peak of $379.5 billion in fiscal 2004. The supply of marketable government debt rose 3.5 percent last year, the smallest increase since 1997.

Treasury bills, securities maturing in less than a year, were cut the most. Fewer bills were sold in fiscal 2005 and 2006 than matured, shrinking the supply by a $50 billion. The government decided in May to discontinue sales of three-year notes in part because officials said they wanted to ``rebuild'' issuance of bills.

The government retired $147 billion of the securities during the third quarter of fiscal 2007, helping to fuel a rally that pushed the yield on three-month securities to a 14-month low of 4.5 percent on June 18. That was less than a week after the 10-year note's yield rose to a five-year high of 5.32 percent.

Growth Estimates

Economists are cutting their growth estimates as the worst housing slump in 16 years erodes consumer confidence. The economy will expand at an annual rate of 1.8 percent this quarter, 0.4 percentage point less than forecast last month, according to the median of 71 analysts surveyed by Bloomberg from Sept. 27 to Oct. 9. Forecasts for the first half of next year also were reduced.

Central bank policy makers on Sept. 18 cut their target rate for overnight loans between banks to 4.75 percent from 5.25 percent, the first reduction since 2003.

``Between the slowdown in the economy and all the financial market turmoil,'' as well as the drop in corporate income tax receipts, ``we have nudged our deficit forecast up,'' said Stephen Stanley, the chief economist at RBS Greenwich in Greenwich, Connecticut.

Three months ago, Stanley forecast a fiscal 2008 gap of $140 billion. It now appears likely to be about $180 billion, he said.

Net Borrowing

Net borrowing during the last three months of the fiscal year totaled about $116 billion, compared with the Treasury Department's July 30 forecast of $73 billion. The agency is scheduled to forecast borrowing estimates for the current and following quarters on Oct. 29.

It now auctions $18 billion of two-year notes and $13 billion of five-year notes every month, the smallest amounts since 2001. Two-year sales are down from a peak of $27 billion in 2003. Five-year notes shrank from $18 billion when their frequency was increased to monthly from quarterly in August 2003.

``We have finally hit a point where the next change in auction sizes is likely to be up rather than down,'' Michael Cloherty, head of U.S. interest-rate strategy in New York at the securities unit of Bank of America, wrote in an Oct. 4 report. The firm revised its forecast for the fiscal 2008 deficit to about $175 billion from $120 billion in April.

The government will increase the two-year auction to $19 billion in May and the five-year sale to $14 billion in July, Cloherty said. He agreed with Crandall that Treasury officials are likely to delay changing the size of their auctions until after April, when the government collects most of its tax revenue.

Fewer Taxes

Companies paid $92.7 billion in income tax during the third quarter, 11.3 percent less than in the same quarter of 2006, when they had a temporary incentive to declare overseas profits, according to Charlotte, North Carolina-based Bank of America, the second-largest bank in the U.S. behind Citigroup Inc.

It was the first year-on-year decline in corporate tax revenue since the third quarter of 2003 and the largest since the first three months of 2001.

The Congressional Budget Office on Oct. 5 estimated corporate tax revenue grew 5 percent in fiscal 2007, after increases of more than 40 percent the previous two years.

``It wasn't too long ago that there was talk of potential buybacks being up for discussion at the Treasury,'' said Pond, the Barclays strategist. ``That speculation was a bit unfounded.''

Last Updated: October 14, 2007 11:01 EDT