The federal budget deficit hasn’t received a lot of press lately, what with all the worries about the U.S. financial system, the home mortgage market, and the rescues that might be necessary to save both.  In fact, it’s a bad sign, since the Bush administration and the Democrats in Congress have joint responsibility for keeping the budget deficit under control, so they would both be crowing about it if they were doing a good job.

We already know the budget deficit is going to return to the $400 billion level – actually $410 billion – in Fiscal 2008, which ends in September. But what is only just now becoming clear is that the $410 billion figure is likely to mark a trough, not a peak, and that a budget deficit of $1 trillion is likely as early as Fiscal 2009 or Fiscal 2010.

The main reason for the probable swing in the deficit is the current period of slow growth and the impending recession.

For example, 2001-02 was a recession but a pretty wimpy one that lasted from March to November 2001. In August 2001 – well into the recession, and after the 2002 budget had been thoroughly debated – the mid-session budget review projected that 2002’s budget would show a surplus of $173 billion. In reality, only 14 months later, the final figure for 2002 showed a deficit of $304 billion, a swing of $477 billion, or 4.5% of gross domestic product (GDP). Add 4.5% of a $15 trillion GDP to Fiscal 2009’s projected $407 billion deficit and you get a deficit of $1.082 trillion. Thus a trillion-dollar deficit is certainly possible without even assuming an administration or Congress go mad, or a re-run of the Great Depression.

The main factor that has made this year’s budget deficit outcome relatively benign, in spite of the $150 billion in tax rebates, is the huge revenue boost from bonuses and capital gains, most of which are received in April. In April 2008, revenue was $404 billion, 16.0% of expected total revenue for the year. That was a new record, not only in amount (which you might expect), but also as a share of the year’s total revenue – the previous record was April 2001, when revenue was 15.5% of the total for the year.

Note that 2007’s stock market gains and Wall Street bonuses were bigger relative to the U.S. economy than those of 2000, the previous record holder, and also that there is a lag between the market turning down (and bonuses beginning to diminish) and tax revenues falling off. The stock market peaked in March 2000, yet it was in 2002-04, not in 2001, that we saw a sharp drop-off in April’s revues as a share of the year’s total. Thus, it is in 2009 and 2010 that we can expect to see a similar drop-off this time around (and probably one that’s somewhat steeper, because April 2008’s record revenue figure was more extreme).

A Budget Deficit Burdened by Billions in Bailouts

In 2001 and 2002, the new Bush administration cut taxes by about $150 billion per annum, and also increased spending (though not for the Iraq War, which began after Fiscal 2002 ended.) It’s pretty unlikely that we will see a similar tax cut in Fiscal 2009 or 2010 (though a short-term stimulus similar to the recent one might be possible).

However, over and above the normal increases in federal spending we will have an additional factor: The cost to the taxpayer of bailing out Fannie Mae (FNM), Freddie Mac (FRE), Bear Stearns Cos. Inc. (BSC) and possibly even the Deposit Insurance Fund itself, should any more banks the size of IndyMac Bancorp Inc. (OTC: IDMC) go bust and require payouts. 

The Congressional Budget Office (CBO) recently estimated the bailout cost for Fannie Mae and Freddie Mac at a total of $25 billion. Don’t believe a word of it! Both political parties seem to want to bail these mortgage giants out, so the CBO appears to be deliberately low-balling the estimate in order to make the bailout go through smoothly.

First, they assume a 50% chance that bailout funds will not be needed (thus reducing the "expected value" of the payout from $50 billion to $25 billion. In reality, while there certainly is a chance that bailout funds might not be needed, it’s nothing like 50%. Fannie Mae and Freddie Mac loaded up their books with subprime mortgages in 2005-2007, and would be insolvent today if they had been forced to account for those assets on the same basis as the Wall Street banks. Thus, the chance that their losses on the rubbish paper they hold will exceed their capital is far more than 50%.

At the other end of the risk spectrum, the CBO admits (deep, deep, in the undergrowth of impenetrable bureaucratic prose, and not included in the summary) that there is a "5% chance" that the bailout will cost more than $100 billion. Market analysts not on the government’s payroll seem to agree that $100 billion to $150 billion is a conservative estimate of the bailout’s cost, with one analyst putting its potential cost as high as $600 billion.

Add to the probable $100 billion to $150 billion cost for rescuing Fannie and Freddie the $300 billion Congressional Budget Office estimate of the cost of currently impending housing bailout legislation, and you will see that even without any expansive 2009 plans of a President John McCain or President Barack Obama, there are plenty of deficit-busting items coming down the pike, which will easily match the cost of 2001 Bush tax cuts. The eventual rise in interest rates to battle inflation will also increase the U.S. Treasury’s funding costs, further increasing deficits.

Therefore, all we need to get the $1 trillion deficit in either Fiscal 2009 or 2010 is a genuine recession, at least as large as the 2001 downturn. Optimists may disagree, but I would rate the chance of such a recession as being pretty high, and indeed would expect a recession rather deeper than the wimpy 2001 affair, perhaps matching the more serious recessions of 1990-91 or even 1981-82.

Positioning for Profit Despite the Budget Deficit

If you think such a recession is likely, you need to invest accordingly. Stocks are no good, because earnings will continue to be battered, so the stock market is unlikely to zoom up. However, the real losers from a trillion-dollar deficit will be U.S. Treasuries, which will no longer appear a safe haven to even the doziest Asian central banks, and so will have to rise in yield to compensate both for the increased funding needs caused by the deficit and the increased inflation we are now experiencing. 

There are two approaches to investing for a trillion dollar deficit:

• First, you can avoid the U.S. junk bond market altogether, and buy foreign bonds denominated in currencies other than dollars. An attractive vehicle for this is the T. Rowe Price International Bond Fund (RPIBX), which has yielded 5.65% to U.S. investors so far in 2008.

• Second, you can buy a fund that shorts Treasury bond futures, profiting from rises in yields. The best known such fund is the Rydex Inverse Government Long Bond Strategy Fund (RYJUX), which increases in price as long-term government bonds decline.

News and Related Story Links:

• Money Morning:
  Paulson Continues to Advocate Potential $25 Billion Bailout of Fannie Mae and Freddie Mac

• Money Morning:
  Election 2008: Obama or McCain – U.S. May Suffer Either Way