As President Barack Obama starts his second term, the bondmarket is already telling him that the administration's forecastsfor economic growth over the next four years are toooptimistic.

The Office of Management and Budget predicts yields on 10-yearTreasury notes will rise to average 4.1 percent in 2015 and 4.9percent in 2017 as the economy expands at about a 4 percent rate inthe second half of Obama's term. Bond prices suggest the yield, nowat about 2 percent, will average below 3 percent two years fromnow, implying that gross domestic product will fall short of OMBprojections, according to data compiled by Bloomberg.

While Obama's legacy may depend on a recovering economy, thebond market is signaling GDP may not in the next few years exceedthe 3.3 percent annual average of the decade preceding thefinancial crisis and tax revenues will fall short of what thepresident needs to close the budget gap. That's not all bad newsbecause Treasury borrowing costs just above last year's record lowsmean easy credit for consumers and companies as well as sustaineddemand for riskier assets such as stocks.

“Clearly, the bond market is on one end of the spectrum andthese guys are on the other end, believing rates are going to go upso fast,” Priya Misra, the head of U.S. rates strategy at Bank ofAmerica Merrill Lynch in New York, one of the 21 primary dealersthat trade with the Federal Reserve, said Feb. 8 in a telephoneinterview.

“The 10-year yield rising to about 5 percent in four years istoo optimistic,” Misra said. “Maybe you could argue that rates area little depressed now, given inflows into bond funds and theFederal Reserve's debt purchases, but this is nothing like a normalrecovery.”

Market expectations reflected in bond yields are consistent withthe median estimate of 84 economists in a Bloomberg survey who saythe U.S. will grow 2.7 percent in 2014. The OMB forecasts 3.5percent next year.

The clashing views come after the 10-year note yield fell as lowas 1.38 percent in July and averaged 1.79 percent in 2012, thelowest since the debt was first issued in 1953. The next threat toObama's forecast is looming as Congress faces a March 1 deadline toavert spending reductions of $1.2 trillion over nine years that maycut growth in 2013 by half, according to the non-partisanCongressional Budget Office.

Colin Kim, director of the Treasury's Office of Debt Management,noted the divergence between the market outlook and his agency'sassumptions during the government's regular quarterly meeting withthe Treasury Borrowing Advisory Committee on Feb. 5, according tominutes posted on the Treasury Department's website.

Yield Curve

The gap between rates implied in the future by the so-calledyield curve of actively traded securities and the administration'sforecasts may be narrower than just looking at the raw numberssuggests. Demand for government bonds has been elevated by FederalReserve purchases and new rules requiring banks to buy the safestassets for their reserves, which have depressed the compensationinvestors demanded for holding longer-term debt.

The Fed has bought more than $2.3 trillion of Treasuries andother securities since 2008, and plans to continue purchasing acombined $85 billion of government and mortgage debt a month topump money into the financial system. Deposits at U.S. banks exceedloans by $2 trillion, with much of the surplus used to buyTreasuries. Bank holdings of Treasuries increased 15 percent to$521.3 billion in the past year.

While slower growth would make it harder for Obama to meet hisdeficit goals, yields below the administration forecast would limitgovernment debt-service costs. Interest on the $16 trillion debthas fallen as Treasury yields stayed about record lows. The U.S.spent $359.8 billion on financing expense in fiscal 2012, down from$454.4 billion in 2011.

Yields on 10-year notes rose five basis points, or 0.05percentage point, to 2 percent last week, according to BloombergBond Trader data. The benchmark 2 percent note maturing in February2023, sold Feb. 13, finished the week at 99 31/32. The yield waslittle changed at 8:49 a.m. in New York.

Treasuries lost 1.1 percent in January, the worst start to ayear since 2009, according to Bank of America Merrill Lynch bondindexes. The yield on the benchmark 10-year note has risen 25 basispoints from 1.76 percent at the end of last year.

Fed debt purchases have pushed corporate and consumer borrowingrates down. Yields on investment-grade corporate bonds dropped to arecord low 2.73 percent on Nov. 8, compared with the 10-yearaverage of 5.02 percent, according to Bank of America Merrill Lynchbond indexes. Freddie Mac said last week rates on 30-year mortgagesaveraged 3.53 percent, down from 6.74 percent in 2007.

Obama Stimulus

Yields on 10-year notes are forecast to climb to 2.25 percent bythe end of the year, according to the median estimate of 65respondents in a Bloomberg News survey. The last time rates wereabove 4.9 percent, the average for 2017 anticipated by the Officeof Management and Budget, was in July 2007 as the financial crisiswas mounting.

Obama said in his Feb. 12 State of the Union address that eventhough the labor market is improving, more needs to be done tocreate jobs. He proposed raising the federal minimum wage to $9 anhour from $7.25 by 2015 and spending $50 billion on urgentinfrastructure projects.

“What we've seen over the last couple of years from both theFederal Reserve and the fiscal authorities is that they are overlyoptimistic on their growth expectations,” Guy LeBas, the chieffixed-income strategist at Janney Montgomery Scott LLC inPhiladelphia, said in a telephone interview on Feb. 14.

“The sources of higher interest yields include higher economicgrowth, increasing inflation expectations and reduced Fed demand.While one of those three might come into play in 2013 or 2014, itis very unlikely that all three do,” said LeBas, who predicts the10-year note yield will end the year at about 2.2 percent.

While the U.S. pulled out of its worst economic downturn sincethe Great Depression during Obama's first term, unemployment hasremained higher than the average of 6.8 percent over the past 10years.

Average weekly earnings adjusted for inflation showed no gain in2012, and the unemployment rate in January rose to 7.9 percent from7.8 percent the month before. The economy unexpectedly shrank by0.1 percent in the fourth quarter.

Jobless Rate

For the three years following the recession that ended in June2009, the jobless rate averaged 9.2 percent and growth afteraccounting for inflation averaged 2.3 percent, Robert Pollin, aprofessor of economics and co-director of the Political EconomyResearch Institute at the University of Massachusetts at Amherst,said in a telephone interview on Feb. 12. That compares to averageunemployment of 6.3 percent and real GDP expansion of 4.5 percentfor the three-year periods following the end of the previous eightrecessions.

“You've got strong headwinds every way you look working againstreturning to the kind of economic growth levels we saw pre-2007,”Alan Wilde, head of fixed-income and currencies in London at BaringAsset Management, which oversees $53 billion, said in a telephoneinterview on Feb. 12.

“The idea that bond yields could return to 4 percent to 5percent, with a nominal growth rate compatible with stableemployment, is still some way off,” he said. “I subscribe to thegently rising scheme of things for Treasury yields rather than arapid burst higher.”

Implied yields may be below Congressional Budget Officeestimates in part because the so-called term premium required byinvestors to hold longer-maturity debt has remained around recordlows, and negative since 2011, amid Fed purchases. A negative termpremium means investors are not requiring any excess return to holdlong-term debt instead of rolling over a series of short-termsecurities as they mature.

“We can't take market implied forward rates today at face valuedue to the Fed's quantitative easing,” Zach Pandl, an interest-ratestrategist in Minneapolis at Columbia Management InvestmentAdvisers LLC, which oversees $340 billion said in a telephoneinterview on Feb. 15. These rates “are related to expectationsabout where the economy and monetary policy is going, but centralbanks are deliberately distorting those rates to stimulaterecovery.”

The premium was minus 0.62 percent last week, up from a recordlow of minus 1.0187 percent on July 24. It averaged 0.916 percentin the decade before the start of the financial crisis in 2007.

Economic Improvement

Even if growth doesn't meet Obama's forecasts, rising home andcar sales show the economy is improving, according to James Smith,chief economist at Parsec Financial in Asheville, North Carolina.His forecast for a 10-year Treasury yield of 4.11 percent at theend of 2013 is the highest in a survey of 64 participants byBloomberg News.

“The flight-to-quality demand and Fed purchases has helped keepyields below the historic 100-year average of about 3 percentagepoints over the inflation rate,” Smith, an economist at the Fed inWashington from 1975 to 1977, said in a telephone interview Feb.14. “But the Fed buying won't last forever and the economy is backto looking more like a typical expansion,” he said. “Marketexpectations always turn on a dime and nobody sees it coming.”

U.S. auto sales per dealership probably will rise to a record in2013, according to Urban Science, a Detroit-based consulting firm.U.S. light-vehicle sales have climbed by at least 10 percent eachof the last three years, including a 13 percent increase last yearthat was the biggest since 1984.

Purchases of new U.S. homes reached 367,000 in 2012, the mostsince 2009 and the first annual gain in seven years.

The Congressional Budget Office assumes the 10-year Treasuryyield will average 5 percent in 2017 with real GDP growing morethan 4 percent in each of the two prior years, according to itslong-term budget and economic outlook report published Feb. 5.Accelerating growth will help boost revenues and narrow the U.S.deficit-to-GDP ratio to 2.4 percent by 2015.

The budget deficit will decrease to $845 billion, the leastsince 2008, or 5.3 percent of GDP, for the current fiscal year,ending September 30, the report said. In fiscal 2012 the deficitamounted to 7 percent of total U.S. output.

Obama called on Congress last week to pass spending reductionsand close tax loopholes to delay the budget cuts, known assequestration, set to begin next month. Republicans have said theywon't consider raising revenue beyond the $650 billion tax increaseon top earners the president won as part of the budget deal enactedon Jan. 2.

Lawmakers agreed to the automatic spending cuts, to be spreadover nine years, as part of a 2011 fiscal deal to raise the U.S.debt limit. The reductions were supposed to be so onerous thatCongress and the president would never let them occur and wouldfind a plan to replace them.

“We seem to be a long way away from 4 percent real growth,”David Brownlee, the head of fixed-income at Sentinel AssetManagement, which oversees more than $18 billion, said in a Feb. 13telephone interview from Montpelier, Vermont. “It's just reallypreliminary to think rates can go up that high.”

Bloomberg News

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