In an article I wrote earlier today, I mentioned that some cracks were beginning to show in the current bull market. It's important, too, to note that weakening financial markets have a difficult time withstanding bad news. Uncertain market environments are particularly vulnerable to unexpected negative shocks.
A vastly overlooked development, one which received virtually no attention in the mainstream media, is the Bush administration's forecast for the U.S. federal budget deficit. The White House says it will widen in the coming year. UBS Securities, which employs some of the most highly respected economists on Wall Street, forecasts the budget deficit will rise to $225 billion in the fiscal year ending Sept. 30, 2008, up a shocking 38 percent from $163 billion in the current fiscal year.
As a result of the expected shortfall, the U.S. Treasury will likely need to issue more Treasury notes and bonds over the coming months. In fact, UBS estimates that sales of Treasury securities could rise by more than 50 percent during the next 12 months.
Meanwhile, the Concord Coalition, a nonpartisan group that advocates a balanced budget, expects the budget deficit to continue to grow over the next several years and to exceed $500 billion by 2013. That's presuming that Congress extends tax cuts slated to expire in 2010 and that government spending increases at its historical rate.
What happens when the supply of bonds rises sharply? You got it: Bond prices fall and yields — that is, long-term interest rates — rise. Even if the Federal Reserve again lowers short-term interest rates in an effort to prevent a recession, it will have lost control over long-term interest rates.
Earlier today, another often-overlooked development (one that I have previously warned against), has cropped up. Central banks throughout the world are significantly curtailing purchases of U.S. Treasury securities — thus demand falls. And when demand for Treasury securities falls, prices decline and yields rise. As a result, we'll probably see mortgage rates rise significantly in the coming months — even though home prices are continuing to fall.
By the way, the U.S. Treasury Department reported this morning that net foreign purchases of Treasury securities fell for the second month in a row during August. Foreign purchases of U.S. stocks also fell sharply during August, the latest month for which data is currently available. (The chart below shows what happened the last time foreigners sold more U.S. stocks than they bought — stocks fell hard.)
For those of you who might question my forecast that economic growth in the U.S. will slow considerably in the months ahead, you should note that Federal Reserve Chairman Ben Bernanke apparently agrees with much of my forecast.
In a speech he gave last night, Bernanke said that problems in the U.S. housing market could slow the economy in early 2008. "Credit is becoming more expensive and more difficult to obtain, which could lead to a further slowdown in economic growth," Bernanke said. "The further contraction in housing is likely to be a significant drag on growth in the current quarter and through early next year."
Bernanke also said the labor market has shown signs of cooling. "A full recovery of market functioning is likely to take some time, and we may well see some setbacks," he said.
As a result of Bernanke's comments, stock prices in general retreated today.
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