Some say it’ll cost $50 billion. Others predict $100 billion. Senate Minority Leader Harry Reid (D-Nevada) goes as far as to predict it will be $150 billion. Whatever the final price tag for federal spending tied to Hurricane Katrina, the impact on the U.S. budget threatens to be more than trivial. The bond market seems to be preparing for no less. The benchmark 10-year Treasury Note’s yield continued rising today, closing the trading session at 4.14%, the highest since August 29.

Contributing to debt traders’ new-found anxieties are fears that the federal budget deficit, officially forecast before Katrina to be $331 billion for the fiscal year ending September 30, 2005, according to an August 15 report issued by the Congressional Budget Office. For FY 2006, the deficit would retreat to $314 billion. Or so the pre-Katrina outlook advised.
The government’s red ink projections look a bit different now, courtesy of Katrina because of spending. The $10.5 billion relief bill enacted last week is merely the first of what’s expected to be several more spending packages tied to the hurricane’s devastation. “Hurricane Katrina will be by far the costliest disaster in United States history, requiring $150 billion to $200 billion in relief, clean-up and reconstruction spending by the federal government, and causing the short-term loss of some 400,000 jobs,” reports The Independent.
Responding to Katrina’s victims “has become our major priority,” Senate Majority Leader Bill Frist (R-Tennessee) said yesterday. That was more than just idle chatter. Frist reportedly delayed a vote on ending the inheritance tax, for instance, which many Republicans have previously said was a priority in reforming the tax system, according to Newsday.
Yet the CBO suggests that not all’s lost, at least relative to what passed for fiscal rectitude in Washington before the hurricane arrived. The best guess at the moment, according to a CBO study published September 6, says that Katrina economic impact “will be significant but not overwhelming.” Specifically, there’s the “potential to reduce growth by between one-half and one percentage point at an annual rate in the second half of 2005,” the CBO warns. Putting that in context, CBO is projecting 3.7% real growth in 2005 and
3.4% in 2006. In fact, the CBO gushes, the impact on a year-to-year basis may even turn out to be as small as a few tenths of a percent of GDP.
But true to form of late in bond land, things are more complicated than they appear when viewed through a trader’s prism. The Katrina effect has convinced a growing number of investors that the Fed will stop raising interest rates sooner rather than later. That includes PIMCO’s Bill Gross, who runs the largest bond fund on the planet. His guess is that the Fed will stop raising rates sometime next year, with Fed funds topping out at 4.0%, or 50 basis points above the current rate.
An end to rate hikes should be good news for bonds. So why all the selling? Analysis by Gross lends a clue. As he writes in his latest missive, it’s time to “cut the fat” from fixed-income portfolios. “If the home asset bubble stops expanding, deflates, or pops any time soon (and I suspect we are only a few short months from at least the first of these three) then the potential for Greenspan’s ‘debt liquidation’ follow-on is something that investors must begin to prepare for,” he warns. “Debt liquidation, as opposed to loan growth, slows an economy or sinks it into recession, generating the higher risk premiums that the [Fed] chairman warns us lie ahead.”
Does this mean it’s time to dump bonds? Perhaps, perhaps not. Even Gross is less than crystal clear on what his own forecast means. “A bullish orientation towards the front-end of the curve therefore should begin to dominate bond strategies,” he opines. “That is not to say that long government bonds won’t go up in price if the ‘system’ suffers some elimination, slower growth, or to be frank, a recession in 2006. It’s just to acknowledge that the better duration-weighted paper lies at the front-end of the curve, especially now that it provides similar yields to longer maturities.”
The post-Katrina world is unfolding fast, but that doesn’t mean that clarity’s just around the corner.