WASHINGTON, June 19 (Reuters) - If U.S. bond yields continue their surprisingly steep climb in coming months and years, the shine will come off a recently brightened budget outlook as interest costs mount.
The yield on the 10-year U.S. Treasury note jumped to its highest level in 15 months on Wednesday after Federal Reserve Chairman Ben Bernanke said the Fed was likely to begin slowing the pace of its bond purchases later this year. Investors took this as confirming their fears that a reduction in Fed stimulus may come sooner than thought.
At 2.35 percent, the 10-year Treasury yield is now already higher than the level forecast by the Congressional Budget Office for both the current quarter and the full 2013 average. In early May, that yield was hovering around 1.6 percent.
If rates continue to climb at a pace beyond the CBO forecasts, interest costs over 10 years could rise by hundreds of billions of dollars a year, said Steve Bell, senior director at the Bipartisan Policy Center and a former Republican Senate Budget Committee chief of staff.
"People who are not worrying about the impact of higher interest rates on the federal deficit are not in touch with reality," Bell said. "One of the reasons we aren't in worse shape than we are now is because interest rates are so abnormally low."
The prospect of higher interest costs could quickly reverse recent optimism over the deficit that was fueled by strong revenue collections due to a healing economy, accelerated capital gains realized late last year and big contributions from government-controlled mortgage funding giants Fannie Mae and Freddie Mac.
In May, these factors contributed to the non-partisan CBO's decision to slash forecasts for the 2013 deficit by $203 billion and for the 10-year deficit by $618 billion. The improvement, along with a further delay in the deadline for raising the debt limit to October or November, has largely sapped any urgency among Congress and the White House to negotiate a new deficit reduction deal.
But should rates stay on their recent trajectory, these budget gains could be wiped out quickly.
The CBO's "baseline" forecast assumes a slow but steady rise in 10-year Treasury rates - about a tenth of a percentage point per quarter, to an average of 4.1 percent for all of 2016.
In late March, Congress' budget referee agency provided an analysis of how higher rate scenarios would affect deficits.
In one, the CBO took the top 10 estimates from the Blue Chip survey of economic indicators, which anticipates an average yield of 2.9 percent in 2014, and 5.6 percent in 2016. It said this would increase net interest costs by $1.14 trillion, not taking into account any effects that the higher rates would have on economic growth.
Another CBO alternative assumes that Treasury yields move back to their averages in the 1990s, a scenario that would add $1.44 trillion in interest costs over 10 years.
These added costs would be offset if the higher interest rates were the result of a strong economy prompting investors to shift away from Treasuries toward riskier assets such as stocks.
Lou Crandall, chief economist at Wrightson ICAP in Jersey City, New Jersey, said that since the Fed is unlikely to raise its short-term benchmark Federal Funds rate any time soon, short-term Treasury rates should remain relatively low, slowing the growth in interest costs. The Treasury sells short-term debt much more often than it auctions longer-term debt.
The CBO interest rate scenarios, including those incorporated into its baseline forecasts, assume that the three-month Treasury bill yield will average less than 0.1 percent through 2014. On Wednesday, the three month bill closed at 0.05 percent.