More issuance seen weighing on U.S. Treasury prices

NEW YORK (Reuters) - A burgeoning U.S. government budget deficit will result in an increasingly burdensome borrowing requirement, pushing up U.S. Treasury yields in the months and years ahead.

The need to fund tottering government sponsored financial institutions, costly wars, and tax rebates to struggling U.S. consumers are all swelling the federal fiscal deficit forcing the Treasury Department to issue more notes and bonds.

"The U.S. has dug itself a massive fiscal hole," said Joseph Quinlan, chief market strategist of global wealth and investment management at Bank of America in New York. "How it gets out, nobody knows," Quinlan added. "My hunch is that the government will be issuing a great deal more debt over the next decade," Quinlan said.

Analysts are quick to point out that first and foremost the Treasury market typically responds to the economic outlook, inflation expectations, and to Federal Reserve interest rate moves, but increased issuance can have a major long term effect in weighing down bond prices and pushing up yields.

"The budget deficit is widening both because of the tax rebate policy as well as a slowdown in tax revenues," said Paul Kasriel, director of economic research with The Northern Trust Company in Chicago.

"In addition to this, the Federal Reserve has become a huge net seller of U.S. Treasury securities," Kasriel said.

"The combination of a rapidly rising deficit on top of the Fed being a net seller is putting upward pressure on Treasury yields," Kasriel said.

The Fed's regular auction facilities to provide financial institutions hit by the year-old credit crisis with cheap cash have shifted more than $200 billion of Treasuries from the U.S. central bank's holdings onto primary dealers' balance sheets since March, Kasriel notes.

Until recently the central bank acted as a de facto long term parking spot for this swathe of Treasuries, which did not trade freely in the market.

But now dealers want to get these Treasuries as cheaply as possible to offset substantial losses from the year-old credit crisis that have depleted their balance sheets.

Yet the global credit crisis and its damage to the economy is a big wild card supporting the safe-haven appeal of U.S. government bond prices, helping to keep U.S. Treasury yields from rising in the short term.

That market dynamic gives the U.S. government a window of opportunity to issue more debt, which markets may soak up readily, some analysts argued.

"In a period where there is a lot of nervousness in the economy and investors want to be safe and liquid, the market can easily handle as much as $500 billion if the Treasury is wise in terms of the maturities they issue," said Len Santow, managing director of economic and financial consulting firm Griggs & Santow in New York.

That $500 billion level is Santow's forecast for the U.S. federal budget deficit in the next fiscal year.

Yet Santow does warn that if the government ramps up issuance of longer-dated Treasuries substantially, that might cause a selloff of these maturities.

"I do have a concern about an over abundance of longer Treasuries, especially the 10-year note. If the Treasury were foolish enough to go to monthly issues, that would probably be a mistake...with respect to mortgage rates or corporate rates," Santow said.

The 10-year Treasury note's yield US10YT=RR is the benchmark off which long term U.S. fixed mortgage rates are set, including the typical 30-year fixed rate mortgage. A rise of those rates would make mortgages more expensive and risk demolishing an already damaged housing market.

Recent Treasury Department indications that 10-year note and 30-year bond issuance may grow, "will increase pressure for the slope of the curve to be steeper than would otherwise be the case," said Ward McCarthy, managing director with Stone & McCarthy Research Associates, in Princeton, New Jersey.

Instead of concentrating issuance on the longer end of the yield curve, "You can make a very good case for Treasury to go back and use some of the shorter maturities," including issuing 3-year and 7-year maturities, Santow said.

Most analysts are not yet factoring in the potential costs should the government have to bail out mortgage finance behemoths Fannie Mae and Freddie Mac, but that scenario would bump up issuance needs dramatically.

Big global financial institutions have taken more than $400 billion of writedowns and losses in the credit crisis.

Now, a second wave of losses and write-downs, among smaller and medium sized banks is also unfolding which may exceed the size of the late 1980s and early 1990s Savings and Loan crisis.

To help these struggling banks, funds of state regulator, the Federal Deposit Insurance Corp., ultimately may need to be topped up by the government issuing more debt also.

"There is a distinct possibility the FDIC is going to have to be recapitalized," said Kasriel.

(Reporting by John Parry;)