Bond Market Punishes Tax Accord

from Barrons:
THE BIGGEST LOSERS in President Obama's deal with the Republican on taxes aren't the Democrats. It's the bond market.
Yields soared in the wake of the plan that will add upwards of $900 billion to the federal deficit, sending bond prices tumbling, especially in the municipal market.
The question then might be asked if higher borrowing costs, especially for the beleaguered state and local government sector and housing market, will offset the thrust from fiscal policy.
Notwithstanding how it was being played in the media, there was no "extension of the Bush tax cuts" in the deal made by Obama with Congressional Republicans. The tax-rate increases slated to take effect on Jan. 1 were staved off for two years, as most forecasters had assumed would happen. So, no surprise there.
For investors, the favorable 15% tax rates for long-term capital gains and qualified dividends also were extended. In addition, the proposed bipartisan calls for the estate tax to resume at 35% with a $5 million exclusion on Jan. 1, instead of the 55% rate on estates over $1 million, as current law calls for.
The other key parts of the deal were a one-year, two-percentage-point reduction in Social Security withholding taxes (FICA on your pay stub) and a 13-month extension of emergency unemployment benefits. Both are designed to spur the economy by increasing the tax-home pay of those who work and maintain spending by those who aren't.
But it's unlikely to help solve that crucial economic problem. Extending jobless benefits pays people to be unemployed, so more of them will be, all else being equal. Nomura chief U.S. economist David Resler estimates the jobless rate may be a full percentage point higher than what it would be absent the long-term benefits, according to a Bloomberg interview. Also, the FICA reduction affects the employee's portion, not the employer's share. Had this cost to employers been reduced, they would have more incentive to hire. So, it's likely that these proposals will fall short of spurring employment.
What is certain is that the tax proposals is the federal budget deficit will be higher than previous estimates, most of which assumed that the current tax rates would continue and the scheduled increases would not be imposed while joblessness hovered near 10%. JP Morgan's economists project a $1.5 trillion shortfall for the current fiscal year, up from their previous $1.2 trillion forecast. For fiscal 2012, their projection is up to $1.2 trillion, from $1.1 trillion, as the two-point-cut in payroll taxes is reversed.
Economists reckon the tax package will add one-half to a full percentage point to real growth in 2011, with estimates now falling in the 3%-4% range. The better growth prospects from the fiscal proposals reduce the chances the Federal Reserve will purchase more than the $600 billion in Treasuries it currently plans; indeed, the central bank could buy less if the economy picks up.
The potential for the Treasury to sell more securities to fund the larger deficit, plus the likelihood that the Fed could buy fewer notes, in more robustly growing economy sent yields soaring. The benchmark 10-year Treasury's yield jumped 24 basis points (hundredths of a percentage point), to 3.17%, a five-month; its price fell nearly two points, or $20 per $1,000 note.
Conversely, one of the day's big winners was the ProShares UltraShort 20+ Year Treasury fund (TBT), an exchange-traded fund that provides two times the inverse of the daily return of the long end of the Treasury market, which gained 4% on more than twice its daily average volume.
Especially hard hit again was the municipal market, which suffered from an omission from the tax deal -- the expected extension of the Build America Bond program, which expires at year-end. BABs are taxable securities issued by state and local governments that receive a 35% federal interest subsidy.
In the 19 months since the program started, some $164 billion of BABs has been issued, according to the Bond Buyer. BABs had siphoned that new-issue supply from the traditional market of tax-exempt muni bonds, thus bolstering their prices and lowering their yields. That prop will be removed after Jan. 1, which sent muni prices tumbling Tuesday.
The BABs program had proven to be an inefficient and costly subsidy for the federal government. Over the next 30 years, Washington may pay out upwards of $100 billion of interest subsidies on BABs. The original cost probably assumed taxes paid on the BABs' interest payments would offset the cost of the subsidies. But the bulk of BABs were purchased by investors who don't render taxes unto the Treasury -- retirement funds, endowments and foreign holders.
Traditional tax-free triple-A munis yielded 4.60% Tuesday, up sharply from 4.48% a day earlier, according to Ken Woods, head of Asset Preservation Advisors in Atlanta. That compares with 4.39% on a federally taxable 30-year Treasury. To a taxable investor in a combined 40% federal and state tax bracket, a 4.60% fully tax-free yield is equivalent to a 7.67% taxable yield -- significantly higher than medium-grade corporates.
Tax-free yields of 7% and more again became available from leveraged closed-end muni funds, the most aggressive vehicle for participating in the sector. That's equivalent to an 11.67% taxable yield for an investor in a 40% bracket -- vastly higher than junk corporates and greater than the historic return from riskier equities, and more than commensurate with the risks posed by the widely publicized pension-fund deficits in states such as Illinois and California.
The sharp rise in bond yields potentially could blunt the impact of the fiscal thrust from the tentative bipartisan tax deal. The 10-year Treasury yield is up a sharp 70 basis points, which is likely to push a 30-year fixed-rate conventional mortgage back toward 5% from 4.67%. Historically low mortgage rates did little to stimulate housing, and refinancings have slowed already.
States and localities, already reeling under budget pressures, hardly need higher borrowing costs. Every basis point rise in Treasury yields also translates into real bucks with trillion-dollar-plus deficits. Only corporations, which already having taken advantage of ultra-low borrowing costs and are flush with cash anyway, would be immune from an uptick in bond yields.
Perhaps the deadening effect of rising bond yields is what took the winds out of the stock market's sails Tuesday. The major averages had been up nearly 1% early in the session but gave back those gains as the fixed-income sector sank.
The bond vigilantes may undo some of what Obama and Congressional leaders have tried to accomplish.