Expected Future Budget Deficits and the U.S. Yield Curve
History Indicates That Larger Deficits Make It Steeper
By Lloyd B. Thomas and Danhua Wu
Danhua Wu is a financial analyst with Morgan Stanley and is currently based in Orlando, Florida. She received her undergraduate training in finance at the Central University of Finance and Economics in China and completed her master's degree in economics from Kansas State University in 2005.
Because of important demographic forces pertaining to impending social security and Medicare entitlement expenditures, very large budget deficits will occur in the next two decades barring significant federal legislation pertaining to these entitlements and/or taxes. The recent flatness in the yield curve notwithstanding, in this paper, we provide evidence that each one percentage point increase in the expected future deficit/GDP ratio increases the spread between ten-year Treasury bond yields and 90-day Treasury bills by 20-50 basis points. Larger expected deficits raise long-term rates more than short-term yield. To avoid crowding out of investment expenditures and the associated adverse effect on future living standards, it is imperative that Congress soon address the problem of looming deficits.