In an unprecedented move, the number of investors fearing a catastrophic stock market crash is rising even with the stock market at 2 ½ year highs.

The unusual dislocation comes from two distinct reasons: a lack of trust in the U.S. financial markets following the so-called Flash Crash last May and the collapse of Lehman Brothers in 2007.

This means the Flash Crash Advisory Commission that met on Friday has a long way to go in restoring confidence to the point that will bring the individual investor back into a market still ruled by high frequency trading, exchange-traded funds and leveraged hedge funds.

The Yale School of Management since 1989 has asked wealthy individual investors monthly to give the “probability of a catastrophic stock market crash in the U.S. in the next six months.”

In the latest survey in December, almost 75 percent of respondents gave it at least a 10 percent chance of happening. That’s up from 68 percent who gave it a 10 percent probability last April, just before the events of May 6, 2010.

“Even though the market is firing on all cylinders, that fear of big losses still looms large for investors in a way that it didn’t prior to the last bear market,” wrote analysts from Bespoke Investment Group in a report citing the Yale data. “Clearly, the financial crisis and the collapse it caused has impacted investor psyche in a big way.”

In the past, fears of a stock market crash in the Yale survey rose as the market declined because investors lost confidence in the economy and companies as share prices declined, and expected a capitulatory end to a bear market. For example, in March 2009 close to 85 percent of investors gave a crash at least a 10 percent chance of occurring. That record high in distrust and low in confidence marked a 12-½ year low in the S&P 500.

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The benchmark has doubled since that low, but investors are not worrying about the prospects for individual stocks as much now now. Instead they are worrying about the still-unchanged system set up by Wall Street and regulators in which equities trade.

The Flash Crash Commission – containing members of the CFTC and SEC – made a series of recommendations for improving market structure Friday, including single stock circuit breakers, a more reliable audit trail on trades, and curbing the use of cancelled trades by high-frequency traders. They still don’t know what actually caused the nearly 1,000-point drop in the Dow Jones Industrial Average in a matter of minutes.

“Nine months after the Flash Crash and the committee is just about getting around to discussing a few things,” said Joe Saluzzi, co-founder of Themis Trading and market infrastructure expert. “This is just the way the high-frequency trading community and their supporters like it. Grind that reform train to a halt. After all, the market has come roaring back and if you didn't sell on May 6th, then nobody got hurt.”
For the agile professional investor, fear of another crash is not really a concern right now. Surveys show bullish sentiment high among the pros. Hedge funds have increased leverage again to pre-Lehman levels. Wall Street banks paid out large year-end bonuses and are about to start paying dividends again. This professional confidence has been reflected in a steady stock market climb since the summer that’s barely experienced a major 1-day drop, let alone crash.

“Though we find the current steady, upward grind in the market to be very unusual, it is important to realize that these low volatility conditions can persist,” said Andrew Barber of Waverly Advisors, in a note. “For instance, from January 2004 to July 2007, 90 day realized volatility in the S&P 500 traded in a range roughly bounded by 7 percent to 13 percent, averaging just above 10 percent for most of that period. Yes, this is 3 1/2 years of volatility roughly equivalent to what we are seeing now.”

Overall volume has been very light in the market though, as the individual investor put more money into bonds last year than stocks in spite of the gains. Strategists said this has been one of the longer bull markets (starting in March 2009) with barely any retail participation. Flows into equity mutual funds did turn positive in January and have continued this month however, according to ICI and TrimTabs.com. Yet the fear of a crash persists.

“Belief in a coming Flash Crash is Chicken Soup for the Underinvested Soul," said Josh Brown, money manager and author of The Reformed Broker blog. “They aren't so much expecting one as hoping for one - so they can rationalize buying into a market that's left them behind.”

Stocks Know No Bounds

And Wall Street ignores all the risks!

Silver Fireworks

Grains Rebound Higher After Short Correction

Like me, I think many covered their shorts today and bought again, moving the market sharply higher.

Natural Gas Resumes Downtrend Following Bearish EIA Report

It will be time to buy again soon.

Silver Shines

Fed Inflation Vs. Organic Inflation -- NOT the Same

You Want Inflation? Here's How To Get It   
Rising prices driven by speculation is not the same as organic inflation, and diverting national income to the banks will not create organic inflation.

The Federal Reserve's stated goal is to create modest inflation. Unfortunately they don't grasp the difference between speculative inflation and organic inflation. The Fed's official goals are to stabilize prices and maintain employment, and its de facto policy to achieve these lofty, high-minded goals is to divert huge sums of the national income to the insolvent banking sector.

The Fed also seeks to bail out the insolvent debt machine by generating some nice solid inflation, to boost the impaired assets held by banks. In other words, the Fed is specifically seeking to create asset inflation, which will eventually enable the banks to appear marginally solvent as their real estate and other assets rise in value.

Let's turn to the origins of the Fed inflation policy, as stated by Chairman Ben Bernanke in his various papers and speeches: deflation VS inflation: an Austrian Analysis:

In a paper from which he earned the sobriquet "Helicopter Ben," Chairman Bernanke provided a thought experiment to demonstrate that any deflation could be defeated: most economists would agree that a large enough helicopter drop [of newly created money] must raise the price level...at some point the public would attempt to convert its increased real wealth into goods and services, spending that would increase aggregate demand and prices.

In a speech a few years later, Bernanke detailed the policy mechanism by which the circulation of dollars might be increased at will: If the Treasury issued debt to purchase private assets and the Fed then purchased an equal amount of Treasury debt with newly created money, the whole operation would be the economic equivalent of direct open-market operations in private assets. "We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation."

Here's the problem with Bernanke's "solution:" the assets he's goosed ever higher (stocks and bonds) are only held indirectly via pension funds for the bottom 80% of the populace. Only the top 10% of the citizenry own enough stocks and bonds directly to experience the "increased real wealth."

As a result, there's no follow-through of higher spending. Bernanke's policies have failed to generate higher spending for a number of fundamental reasons.

The distinction between housing assets and equity assets is absolutely critical, but it's completely lost on the Fed. We can see Bernanke's game plan in action in the most recent Fed Flow of Funds.

Housing equity has plummeted roughly $6 trillion from the bubble peak to Q3 2010 (and it has slipped further since): $22.6 trillion to $16.5 trillion.

Stocks and bonds, meanwhile, have gained $6 trillion--a nice symmetry. In Q1 2009, corporate equities ($5 T), mutual funds ($3.1 T) and pension fund reserves ($10.4 T) added up to $18.5 trillion. By Q3 2010, these had risen smartly to $24.4 trillion (corporate equities $7.8 T, mutual funds $4.4 T and pension fund reserves $12.2 T)

Housing is the primary household asset for roughly 2/3 of U.S. households, while stocks and bonds are the primary asset for only the top 5%. So what Bernanke has effectively overseen is a massive transfer of private wealth.

He's also accomplished a stupendous transfer of national income to the financial Elites in the banking sector by lowering interest rates to zero (ZIRP). Back in the low inflation 1960s, banks and savings and loans were required to pay 5.25% on all savings. Cash, in other words, generated substantial income for ordinary savers.

The idea with ZIRP is to loan the banks essentially free money, which they can lend out at between 5% and 12% (or higher), generating "free" profits. The Fed's plan is to sluice these gigantic profits to banks so they can recapitalize their insolvent balance sheets without any direct handouts. But ZIRP is nothing but an indirect transfer of wealth from the private sector (now completely deprived of any interest income) to the banks.

The Fed's policies allow for only two ways to access this newly created "increase in real wealth" for the top 10%: sell the assets or borrow money from the banks. If people cash out their stock gains, then that would automatically push stocks lower, bollixing the game plan. The Fed's intention is to "nudge" the populace into borrowing more money from the banks at nominally high rates of interest (anythijng above 0% is pure profit for the banks).

Unfortunately for the Fed, those with rising assets are no longer hankering for higher debt levels, and the bottom 80% are no longer qualified to borrow. So what we have is a speculative asset inflation which is spilling over into commodities as hot money borrowed for next to nothing seeks higher returns anywhere on the planet.

Contrast this with organic inflation, in which people with lots of free cash are chasing limited goods and services.

Inflation itself is a transfer of wealth. As noted in the paper linked above:

In short, the true crux of deflation is that it does not hide the redistribution going hand in hand with changes in the quantity of money. It entails visible misery for many people, to the benefit of equally visible winners. This starkly contrasts with inflation, which creates anonymous winners at the expense of anonymous losers.

Inflation is a secret rip-off and thus the perfect vehicle for the exploitation of a population through its (false) elites, whereas deflation means open redistribution through bankruptcy according to the law.

The reason that public sentiment has always been biased against monetary deflation can be found in the manner in which wealth transfer occurs under inflationary and deflationary environments. During an inflationary credit expansion, wealth is transferred from the public in general to the earliest recipients of the newly created credit money. In practice the earliest recipients are interest groups with the strongest political connections to the State and, in particular, the State institutions that control monetary policy (i.e., the Federal Reserve in the United States).

Importantly, the wealth transfer that takes place during an inflation is hidden and largely unrecognized by the majority of the population. The population is unaware that the supply of money is increasing and the attendant rise in prices, ostensibly beneficial to business, initially produces [a] general state of euphoria, a false sense of well-being, in which everybody seems to prosper.

Those who without inflation would have made high profits make still higher ones. Those who would have made normal profits make unusually high ones. And not only businesses which were near failure but even some which ought to fail are kept above water by the unexpected boom. There is a general excess of demand over supply--all is saleable and everybody can continue what he had been doing.


And here precisely lies the answer to why the State prefers a policy of controlled inflation. Only in an inflationary environment can State largesse be conferred to the politically well-connected without raising public ire. The widespread and visible transfers of property through bankruptcy that must take place during a deflation are often politically destabilizing and thus highly unappealing to any regime. A sense of injustice grows within the population as banks are saved from the folly of their misguided investments with taxpayer-funded bailouts, while debtors with no political clout have property seized in bankruptcy.

Here is where we are in a nutshell. The general populace has seen its income decline as the Fed's ZIRP policy has channeled their interest income directly into the banks, and as their wages stagnate.

Yet thanks to the speculative inflation engineered by the Fed, prices are rising. In an organic inflation, wages and interest income would both be rising along with prices. So the direct result of the Fed's policies is higher costs and the transfer of national income to the banks.

The average household has seen its income and its asset base (housing) stagnate or decline. Meanwhile, the equities market, which directly "increases real wealth" in only the top 10%, has risen over 80% from the Q1 2009 low.

If the bottom 80% are seeing income and assets stagnate or decline, how can you possibly get organic inflation? Answer: you can't. And speculative inflation only benefits the top financial players, not the general populace.

If we combine this chart and the Fed Flow of Funds data, we find that mortgages total $10.1 trillion and other consumer debt is about $3 trillion.


You want to create organic inflation, driven by consumers with plenty of cash chasing goods and services? Here's how:

1. Reinstate the policy of paying 5.25% on all savings, effectively transferring wealth back from banks to citizens. If the banks can't manage to do so and remain solvent, then close them down and liquidiate their assets and liabilities. Others will rise to take their places.

2. Print $5 trillion in cash, not credit, and liquidate all consumer debt and a couple trillion in mortgage debt for those who are not hopelessly underwater.

3. Aggressively cram down underwater mortgages onto the banks, forcing them to liquidate all their bad debt. Yes, this will reveal them as insolvent, but the goal here is not to save the financial Elites' impaired assets, it's to reset the housing market by clearing off all the impaired debt in the system.

By resetting the consumer balance sheet and paying interest, then you would be putting cash into households which could be spent in the real economy.

Is this a wise or prudent policy? I don't know. The goal here was not to assess that question, it was simply to follow up on the goal of creating inflation. If you want organic inflation, you have to divert the national income from the banks to the citizenry, and you have to reset the housing market.

The Fed's policies cannot create organic inflation, because all the Fed is doing is transferring wealth to the nation's Elites. Their spending on luxuries and fine dining are not broadbased enough to generate organic inflation in the entire economy.

Borrowing money does not drive organic inflation: higher incomes and free cash drive organic inflation. If you want inflation, then you have to increase the incomes and assets of 60% of the households, not just the top sliver who own most of the financial assets.

Housing Starts Increased, But Mortgage Applications Plunged

And that means an ever more overbuilt housing market. Not a good sign!

Inflation 66% Higher Than Fed Reports

from Daily Finance:

By DAN BURROWS Posted 6:30 AM 02/16/11 Economy, Investing

Comments Print Text Size A A A Email This

Global food prices are at an all-time high, U.S. gasoline prices are at the costliest level ever for this time of the year and yet inflation, in the words of Federal Reserve Chairman Ben Bernanke, remains "quite low."

By official reckoning, that's certainly the case. On Thursday we'll get the latest monthly inflation figures in the form of the consumer price index, which, to the Fed chief's chagrin, is running too close to disinflationary levels. Economists, on average, expect January prices to increase at just a 0.3% rate. So-called core inflation, which excludes volatile food and energy prices, is forecast to rise just 0.1%.

As Bernanke testified before Congress last week, economists exclude food and energy prices because that core inflation rate "can be a better predictor of where overall inflation is headed." By that measure, inflation was only 0.7% in 2010, compared with around 2.5% in 2007, the year before the recession began, the Fed chief explained.

Too bad those numbers don't jibe with with most folks' experience at the gas pump or checkout counter. As economist Ed Yardeni, president of Yardeni Research, told clients Tuesday: "I share the growing concern among the Fed's critics that the official measures of consumer price inflation may be understating actual inflation and that excluding food and energy from these measures is OK as long as you don't eat or drive."



Alternative measures for inflation show a far more alarming picture of price increases than the official data suggest. One of the more intriguing approaches is The Billion Prices Project at the Massachusetts Institute of Technology, which collects daily price changes on about 5 million items sold by approximately 300 online retailers in more than 70 countries.

For U.S. price data, MIT tracks 550,000 products from 53 retailers. By this measure, annual inflation is currently running at a rate of 2.5% -- or 66% greater than the official CPI figure. See the chart above.

Core inflation may have run at just 0.7% in 2010, as Bernanke says, which is the lowest reading on record gong back to 1960. Even if you add back in those pesky food and energy prices, the number rises to 1.2% -- still no big deal. But by the Billion Prices Project's reading, inflation in 2010 more than doubled to 2.5%. "The Billion Prices Project @ MIT is finding plenty of evidence that consumer prices are rising faster than the official price data," Yardeni notes.

Whatever the latest data show Thursday, there's a big difference between inflation as a guide for monetary policy and its real-world impact on conusmers' pocketbooks.

PPI Up .8%, Housing Starts Rises

from Zero Hedge:

The PPI including food and energy came at 0.8%, in line with expectations, and a decline from the previous 1.1%. Ex food and energy, Producer Prices jumped from 0.2% to 0.5%, and over 100% higher than expectations of 0.2%. Somehow, food PPI increased by just 0.3%, the lowest since August, and once again making one wonder which Department of Truth is more unbelievable: ours or the Chinese. From the release: The Producer Price Index for finished goods rose 0.8 percent in January, seasonally adjusted, the U.S. Bureau of Labor Statistics reported today. This advance followed increases of 0.9 percent in December and 0.7 percent in November and marks the seventh straight rise in finished goods prices. At the earlier stages of processing, prices received by manufacturers of intermediate goods moved up 1.1 percent, and the crude goods index rose 3.3 percent. On an unadjusted basis, prices for finished goods advanced 3.6 percent for the 12 months ended January 2011.... The index for finished consumer foods moved up 0.3 percent in January, the fifth consecutive monthly increase. A 13.7-percent advance in prices for fresh and dry vegetables was the main factor in the January rise in the finished consumer foods index...In January, the index for intermediate foods and feeds moved up 0.4 percent for the second consecutive month. A 2.7-percent rise in beef and veal prices accounted for about forty percent of the January increase in the intermediate foods index.

Deficit As Proportion of Economy Hits Post-War Record

from MyWay:

WASHINGTON (AP) - Not since World War II has the federal budget deficit made up such a big chunk of the U.S. economy. And within two or three years, economists fear the result could be sharply higher interest rates that would slow economic growth.
The budget plan President Barack Obama sent Congress on Monday foresees a record deficit of $1.65 trillion this year. That would be just under 11 percent of the $14 trillion economy - the largest proportion since 1945, when wartime spending swelled the deficit to 21.5 percent of U.S. gross domestic product.
The danger is that a persistently large gap in the budget could threaten the economy. Investors would see lending their money to the U.S. as riskier. So they'd demand higher returns to do it. Or they'd simply put their cash elsewhere. Interest rates on mortgages and other debt would rise as a result.
And if borrowing turned more expensive, people and businesses might scale back their spending. That would weaken an economy still struggling to lower unemployment, revive real estate prices and restore corporate and consumer confidence.
So far, it hasn't happened. It's still cheap for the government to borrow money and finance deficits. But economists fear the domino effect if all that changes.
"The moment when markets react negatively to our budget deficit cannot be known in advance, but we are absolutely in the danger zone," says Marvin Goodfriend, an economics professor at Carnegie Mellon University's Tepper School of Business.
Higher interest rates would also raise interest payments on the federal debt. It would be costlier for the government to finance its operations. The interest payments themselves could then make the deficit increase, creating a vicious cycle.
Under the projections in Obama's budget, the deficit as a share of the overall economy would narrow from 10.9 percent this year to 7 percent next year and eventually to 2.9 percent by the 2018 fiscal year.
But after that, in the remaining years of this decade, the deficit would widen slightly as a percentage of the economy. It would average about 3.1 percent because of escalating costs for programs like Social Security and Medicare as baby boomers age and receive benefits.
Economists generally say cutting the deficit to about 3 percent or less of the economy would be healthy. Deficits at that level are considered "sustainable" - meaning they could be easily financed and wouldn't make investors nervous about the government's finances.
Most economists don't think the deficit should be cut deeply now. They say the economy remains so fragile - unemployment is at 9 percent - that it needs big government spending to invigorate growth.
In this camp is Federal Reserve Chairman Ben Bernanke. He's argued that now isn't the time to slash government spending or raise taxes. Instead, Bernanke has urged Congress and the White House to preserve federal stimulus - including tax cuts - in the short run but draft a plan to reduce the deficit over the long run.
A presidential commission last year made recommendations that Bernanke and other economists say could help curb the deficit over the long term. Its suggestions included raising the Social Security retirement age and reducing future increases in benefits. It also proposed increasing the gasoline tax and eliminating or scaling back tax breaks, like the mortgage interest deduction claimed by many Americans.
Obama embraced none of these proposals in his budget. But his plan is designed to cut $1.1 trillion from the deficit over the next decade, two-thirds of it from spending cuts. The rest would come from tax increases, such as limiting the deductions for high-income taxpayers.
In Bernanke's view, a long-term plan to reduce future deficits would mean lower long-term interest rates and increased consumer and business confidence.
For months, though, longer-term rates have been creeping up, driven by prospects of stronger growth and concerns about higher inflation. The yield on the 10-year Treasury note is now 3.61 percent. That's up sharply from 2.48 percent in early November.
That increase is making other loans, including mortgages, more expensive. The average rate for a 30-year fixed mortgage just rose above 5 percent for the first time since April.
Rates are still extremely low by historical standards. In 1983, during Ronald Reagan's first presidential term, the deficit soared to $208 billion, about 6 percent of the economy at the time. The rate on the 10-year note topped 10 percent. And getting a 30-year mortgage meant paying 13 percent.
Economists say that if investors trust that Congress and the White House will curb budget deficits over the long haul, interest rates could stabilize - even if deficits exceed $1 trillion over the next year or two. But if investors lose confidence that Washington policymakers can curb the deficits, rates could rise sharply.
"It's all about perception," says Lou Crandall, chief economist at Wrightson ICAP, a research firm.
So far, China, the biggest buyer of U.S. debt, and other countries have maintained their appetites for Treasurys. Foreign demand for Treasury debt has helped keep U.S. interest rates historically low.
The reason is that the United States is still considered a haven for many foreign investors. That point was underscored by Europe's debt crisis last year, when money poured into dollar-denominated Treasurys.
If the United States had to finance its debt through U.S. investors alone, the government, along with American companies and consumers, would have to pay higher rates.
Last year's budget deficit totaled $1.3 trillion. That was just under 9 percent of U.S. economic activity. The first time the deficit topped $1 trillion was in 2009.
The growth of U.S. budget deficits has reflected the costs of the wars in Iraq and Afghanistan, the continuation of broad tax cuts, the worst recession since the 1930s and a surge in spending on Social Security, Medicare and the military. The recession prompted higher government spending to stimulate the economy and cushion the effects of the downturn. It also reduced tax revenue.
The Organization for Economic Cooperation and Development estimates that the United States' deficit as a share of the U.S. economy will be smaller - around 8.8 percent- than the president's budget estimates.
Still, that would be a higher figure than for other major industrialized countries. The OECD projects, for example, that Britain's deficit this year will be about 8.1 percent of its economy. Germany's deficit is expected to make up 2.9 percent of its economy, Japan's 7.5 percent.
"So far, investors haven't been bothered by large U.S. budget deficits," says Jim O'Sullivan, economist at MF Global, an investment firm. "The fear is that could suddenly change. It's not clear whether investors will remain patient once the U.S. recovery is on track."

Unctuous Obama!

from WSJ:
WASHINGTON—The White House projected Monday that the federal deficit would spike to $1.65 trillion in the current fiscal year, the largest dollar amount ever, adding pressure on Democrats and Republicans to tackle growing levels of debt.
The projected deficit for 2011 is fueled in part by a tax-cut extension that President Barack Obama and Republican lawmakers brokered in December, two senior administration officials said. It would equal 10.9% of gross domestic product, the largest deficit as a share of the economy since World War II.
The new estimate is part of Mr. Obama's proposed budget for fiscal year 2012, which becomes public Monday morning.
Mr. Obama is proposing $3.73 trillion in government spending in the next fiscal year, part of a plan that includes budget cuts and tax increases that administration officials believe will sharply bring down the federal deficit over 10 years.

from Washington Examiner:
President Obama projects that the gross federal debt will top $15 trillion this year, officially equalling the size of the entire U.S. economy, and will jump to nearly $21 trillion in five years’ time.
Amid the other staggering numbers in the budget Mr. Obama sent to Congress on Monday, the debt stands out — both because Congress will need to vote to raise the debt limit later this year, and because the numbers are so large.
Mr. Obama‘s budget said 2011 will see the biggest one-year jump in debt in history, or nearly $2 trillion in a single year. And the administration says it will reach $15.476 trillion by Sept. 30, the end of the fiscal year, to reach 102.6 percent of gross domestic product (GDP) — the first time since World War II that dubious figure has been reached.
In one often-cited study, two economists have argued that when gross debt passes 90 percent it hinders overall economic growth.
The president’s budget said debt as a percentage of GDP will top out at 106 percent in 2013, but only if the economy booms.
“I still don’t see a sense of urgency from the president about the massive federal debt,” said Sen. Lamar Alexander, Tennessee Republican. “His budget calls for too much government borrowing – even though the debt is already at a level that makes it harder to create private-sector jobs.”  
Speaking on MSNBC on Monday, Jacob “Jack” Lew, the White House budget director, said their long-term plan to lower deficits will stabilize the debt.
“When we came into office, when President Obama took office, the deficit was climbing to over 10 percent of the economy. We have a plan that would bring it down to 3 percent,” he said. “That is the most rapid reduction in the deficit in history. It is what we have to do to be able to say we’re paying our bills and we’re not adding to the debt.”
The administration said debt as a percentage of GDP will stabilize at about 105 percent in the middle of this decade, though those calculations assume economic growth levels significantly above projections of the non-partisan Congressional Budget Office.
The government measures debt several ways. Debt held by the public includes the money borrowed from Social Security’s trust fund.

Geithner Admits Interest Costs to Surge

from Bloomberg:
Barack Obama may lose the advantage of low borrowing costs as the U.S. Treasury Department says what it pays to service the national debt is poised to triple amid record budget deficits.
Interest expense will rise to 3.1 percent of gross domestic product by 2016, from 1.3 percent in 2010 with the government forecast to run cumulative deficits of more than $4 trillion through the end of 2015, according to page 23 of a 24-page presentation made to a 13-member committee of bond dealers and investors that meet quarterly with Treasury officials.
While some of the lowest borrowing costs on record have helped the economy recover from its worst financial crisis since the Great Depression, bond yields are now rising as growth resumes. Net interest expense will triple to an all-time high of $554 billion in 2015 from $185 billion in 2010, according to the Obama administration’s adjusted 2011 budget.
“It’s a slow train wreck coming and we all know it’s going to happen,” said Bret Barker, an interest-rate analyst at Los Angeles-based TCW Group Inc., which manages about $115 billion in assets. “It’s just a question of whether we want to deal with it. There are huge structural changes that have to go on with this economy.”
The amount of marketable U.S. government debt outstanding has risen to $8.96 trillion from $5.8 trillion at the end of 2008, according to the Treasury Department. Debt-service costs will climb to 82 percent of the $757 billion shortfall projected for 2016 from about 12 percent in last year’s deficit, according to the budget projections.

Budget Proposal

That compares with 69 percent for Portugal, whose bonds have plummeted on speculation it may need to be bailed out by the European Union and International Monetary Fund.
Forecasts of higher interest expenses raises the pressure on Obama to plan for trimming the deficit. The President, who has called for a five-year freeze on discretionary spending other than national security, is scheduled to release his proposed fiscal 2012 budget today as his administration and Congress negotiate boosting the $14.3 trillion debt ceiling.
“If government debt and deficits were actually to grow at the pace envisioned, the economic and financial effects would be severe,” Federal Reserve Chairman Ben S. Bernanke told the House Budget Committee Feb. 9. “Sustained high rates of government borrowing would both drain funds away from private investment and increase our debt to foreigners, with adverse long-run effects on U.S. output, incomes, and standards of living.”

Yield Forecasts

Treasuries lost 2.67 percent last quarter, even after reinvested interest, and are down 1.54 percent this year, Bank of America Merrill Lynch index data show. Yields rose last week to an average of 2.19 percent for all maturities from 2010’s low of 1.30 percent on Nov. 4.
The yield on benchmark 10-year Treasury note will climb to 4.25 by the end of the second quarter of 2012, from 3.63 percent last week, according to the median estimate of 51 economists and strategists surveyed by Bloomberg News. The rate was 3.64 percent as of 2:08 p.m. today in Tokyo. The economy will grow 3.2 percent in 2011, the fastest pace since 2004, according to another poll.
“People are starting to come to the conclusion that you’ve got a self-sustaining recovery going on here,” said Thomas Girard who helps manage $133 billion in fixed income at New York Life Investment Management in New York. “When interest rates start to go back up because of the normal business cycle, debt service costs have the potential to just skyrocket. Every day that we don’t address this in a meaningful way it gets more and more dangerous.”

‘Kind of Disruption’

While yields on the benchmark 10-year note are up, they remain below the average of 4.14 percent over the past decade as Europe’s debt crisis bolsters investor demand for safer assets, Bank of America Merrill Lynch index data show.
“The market is still giving the U.S. government the benefit of the doubt,” said Eric Pellicciaro, New York-based head of global rates investments at BlackRock Inc., which manages about $3.56 trillion in assets. “What we’re concerned with is whether the budget will only be corrected after the market has tested them. Will we need some kind of disruption within the bond market before they’ll actually do anything.”
Still, U.S. spending on debt service accounts for 1.7 percent of its GDP compared with 2.5 percent for Germany, 2.6 percent for the United Kingdom and a median of 1.2 percent for AAA rated sovereign issuers, according to a study by Standard & Poor’s published Dec. 24. Among AA rated nations, China’s ratio is 0.4 percent, while Japan’s is 2.9 percent, and for BBB rated countries, Mexico devotes 1.7 percent of its output to debt service and Brazil 5.2 percent, the report shows.

Auction Demand

Demand for Treasuries remains close to record levels at government debt auctions. Investors bid $3.04 for each dollar of bonds sold in the government’s $178 billion of auctions last month, the most since September, according to data compiled by Bloomberg. Indirect bidders, a group that includes foreign central banks, bought a record 71 percent, or $17 billion of the $24 billion in 10-year notes offered on Feb. 9.
Foreign holdings of Treasuries have increased 18 percent to $4.35 trillion through November. China, the largest overseas holder, has increased its stake by 0.1 percent to $895.6 billion, and Japan, the second largest, boosted its by 14.6 percent to $877.2 billion.

‘Killing Itself’

“China cannot dump Treasuries without killing itself,” said Michael Cheah, who oversees $2 billion in bonds at SunAmerica Asset Management in Jersey City, New Jersey. “They’re holding Treasuries as a means to an end,” said Cheah, who worked at the Singapore Monetary Authority from 1982 through 1999, and now teaches finance classes at New York University and at Chinese universities. “It’s part of what’s needed to promote exports.”
At least some of the increase in interest expense is related to an effort by the Treasury to extend the average maturity of its debt when rates are relatively low by selling more long-term bonds, which have higher yields than short-term notes. The average life of the U.S. debt is 59 months, up from 49.4 months in March 2009. That was the lowest since 1984.
The U.S. produced four budget surpluses from 1998 through 2001, the first since 1969, as the expanding economy, declining rates and a boom in stock prices combined to swell tax receipts.
Tax cuts in 2001 and 2003, the strain of the Sept. 11 terror attacks, the cost of funding wars in Afghanistan and Iraq, the collapse in home prices and the subsequent recession and financial crisis has led to the three largest deficits in dollar terms on record, totaling $3.17 trillion the past three years.

‘Demonstrates Confidence’

The U.S. needs to manage its spending decisions “in a way that demonstrates confidence to investors so we can bring down our long-term fiscal deficits, because if we don’t do that, it’s going to hurt future growth,” Treasury Secretary Timothy F. Geithner said in Washington on Feb. 9.
The Treasury Borrowing Advisory Committee, which includes representatives from firms ranging from Goldman Sachs Group Inc. to Soros Fund Management LLC, expressed concern in the Feb. 1 report that the U.S. is exposing itself to the risk that demand erodes unless it cultivates more domestic demand.
“A more diversified debt holder base would prepare the Treasury for a potential decline in foreign participation,” the report said.
Foreign investors held 49.7 percent of the $8.75 trillion of public Treasury debt outstanding as of November, down from as high as 55.7 percent in April 2008 after the collapse of Bear Stearns Cos., according to Treasury data.

Potential Demand

The committee projects there may be $2.4 trillion in latent demand for Treasuries from banks, insurance companies and pension funds as well as individual investors. New securities with maturities as long as 100 years, as well as callable Treasuries or bonds whose principal is linked to the growth of the economy might entice potential lenders, the report said.
“They are opening up a can of worms with the idea of all these other instruments,” said Tom di Galoma, head of U.S. rates trading at Guggenheim Partners LLC, a New York-based brokerage for institutional investors. “They should try to keep the Treasury issuance as simple as possible. The more issuance you have in particular issue, the more people will trade them -- whether it be domestic or foreign investors.”
White House Budget Director Jacob Lew said the Obama administration’s 2012 budget would save $1.1 trillion over the next 10 years by cutting programs to rein in a deficit that may reach a record $1.5 trillion this year.
“We have to start living within our means,” Lew said yesterday on CNN’s “State of the Union” program.
Still, about $4.5 trillion, or 63 percent of the $7.2 trillion in public Treasury coupon debt, needs to be refinanced by 2016. That gives the government a narrowing window as growing interest expense will curtail its ability to spend.
“There is roll-over risk,” said James Caron, head of U.S. interest-rate strategy at Morgan Stanley in New York, one of 20 primary dealers that trade with the Fed. “It’s a vicious cycle.”

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