At a time when U.S. bond yields are rising at the fastest pace in more than a year, the amount the government pays to service its record deficit is the lowest since 2005 compared with the size of the economy. While interest costs rose 8 percent to $414 billion in the fiscal year ended Sept. 30 from $383.4 billion in 2009, they fell to 2.7 percent of gross domestic product from 3.1 percent, U.S. Treasury Department data show. That’s the lowest in five years, when it was the same percentage, and below the 3.6 percent in 2001, when the U.S. last had a budget surplus. Benchmark 10-year Treasury note yields rose last week by the most since August 2009. Bond prices tumbled as President Barack Obama’s agreement to extend Bush-era tax cuts showed the government is ready to increase the deficit to lower the jobless rate at the same time the Federal Reserve prints money to ward off deflation. “It is an inflection point when the interest costs on the government’s debt starts to rise because the amount of debt is so high,” said Phillip Swagel, assistant secretary for economic policy at the Treasury in 2007 and 2008 who’s now a professor at Georgetown University in Washington. “Rates are still reasonably low. But at some point increasing interest costs is going to be what forces more action on this issue.” Adding to Debt The agreement between Obama and Senate leaders set the estate tax at the lowest rate in 80 years, extended jobless aid and cut payroll taxes by 2 percentage points. The proposed legislation would add $857 billion to the federal debt over 10 years, government analysts said. On Dec. 7, the day after Obama announced the tax deal, demand at the government’s auction of $32 billion in three-year notes was the least since February. The Treasury said it received $2.91 in bids for each $1 of the notes sold, down from $3.26 a month earlier. Ten-year yields rose 31 basis points last week, or 0.31 percentage point, the most since August 2009. The benchmark note yielded 3.37 percent as of 1:53 p.m. in Tokyo, according to BGCantor Market Data, the highest since June. The 2.625 percent security due in November 2020 fell 3/8, or $3.75 per $1,000 face amount, to 93 3/4. Even with the increase, yields remain more than two percentage points below the 5.44 percent average of the past two decades. The average for Treasury notes and bonds fell to about 1.90 percent on Dec. 10 from 2.07 percent a year ago, according to Bank of America Merrill Lynch’s U.S. Treasury Master Index. Yield Forecasts Ten-year yields will be little changed at 3.30 percent by the end of the third quarter, according to the median estimate of more than 60 economists and strategists surveyed by Bloomberg. Two-year note yields may rise to 1 percent from 0.68 percent, according to the survey. “The deficit situation will improve as long-term growth improves,” said Jeffrey Caughron, associate partner in Oklahoma City at Baker Group LP, which advises community banks on investing assets totaling $23 billion. “Bond yields will move back to the range we’ve seen for the last 12 to 18 months, but they won’t move dramatically higher.” Obama has directed his economic team to begin analyzing options for overhauling the U.S. tax code to help trim the long- term deficit, an administration official said Dec. 10. No decisions have been made about options or a timeline for presenting a plan to lawmakers, said the official, speaking on condition of anonymity because no formal action has been taken. Rising Expense Interest paid by the Treasury to service its debt in the first two months of fiscal 2011 rose 6.9 percent to $43.5 billion from $40.7 billion in the period a year earlier in part because the government has taken advantage of record-low borrowing costs to sell more longer-dated securities. The average maturity of marketable Treasury debt rose to 59 months from 49.4 months in March 2009 while the outstanding amount jumped 25 percent to $8.75 trillion in November from $7.01 trillion at the end of fiscal 2009, according to government data. “The Treasury is still going to be borrowing an enormous amount and interest rates are off the lows,” said Ward McCarthy, chief financial economist at New York-based Jefferies & Co. “There is a good chance that interest expense will continue to increase, which is a consequence of the massive budget deficit that we are running these days.” Fiscal Deficit Economists at New York-based Morgan Stanley project the 2011 fiscal deficit will total $1.295 trillion, assuming the tax plan is implemented, compared with $1.3 trillion in the year ended Sept. 30. That would equal 8.6 percent of GDP, based on the firm’s economic growth forecast. The shortfall would total $1.11 trillion, or 7 percent of the economy, in 2012, they said. At the start of the year, Morgan Stanley expected 10-year yields to reach 5.5 percent by the end of December. Now, the firm says they may only rise to 4 percent by the end of 2011. The deficit swelled from $455 billion in 2008 because of government programs to jolt the economy out of its deepest slump since the Great Depression. U.S. debt sales rose to a record $2.15 trillion this year from $2.109 trillion in 2009. Bond yields fell, with the 10-year Treasury rate bottoming at 2.33 percent in October when the consumer price index excluding food and energy rose 0.6 percent from a year earlier, the smallest increase on record. It’s rising now on speculation the Fed’s plan to buy $600 billion of U.S. debt through June will help spark the economy and inflation. Pimco’s Outlook Bill Gross, who oversees the world’s largest bond fund at Pacific Investment Management Co., said in October that asset purchases by the Fed likely signifies the end of the 30-year bull market in bonds. Fiscal stimulus will help the economy expand as much as 3.5 percent next year, according to Mohamed El-Erian, the chief executive officer of Pimco, which oversees $1.24 trillion. That compares with the 2.2 percent gain forecast for this year by the International Monetary Fund. “The U.S. is using fiscal and monetary policy to try to attain escape velocity for the economy,” El-Erian said in a telephone interview on Dec. 9 from Newport Beach, California. “What we don’t know yet is whether that will be enough not just to change the economy’s trajectory for one year but to place it on a medium-term sustainable path.” Gross domestic product expanded at a 2.5 percent annual rate in the third quarter, according to a government report on Nov. 23. Then on Dec. 3 the Labor Department said the unemployment rate rose to 9.8 percent in November, the highest since 9.9 percent in April. Bond Losses U.S. government debt has lost 3.4 percent on average, including reinvested interest, since 10-year Treasury yields bottomed on Oct. 8, according to the Bank of America Merrill Lynch index. That compares with a total return of about 7 percent for the Standard & Poor’s 500 index. The five-year, five-year forward breakeven rate the Fed uses to chart investor expectations for inflation surged to 3.09 percent last week from an almost two-year low of 2.18 percent on Aug. 24. The rate averaged 2.6 percent the five years before the beginning of the financial crisis. “All the talk about deficits has re-awakened bond investors to the realization that we have a very serious long- run problem,” said Robert Litan, a senior fellow at the Brookings Institution in Washington and former associate director of the Office of Management and Budget in 1995 and 1996. “There has been bond market ostrich behavior with people thinking ‘well deficits don’t matter,’” he said. “The rise in yields is a natural correction as we had a semi-bond market bubble beforehand with interest rates being too low for too long.” To contact the reporters on this story: Liz Capo McCormick in New York at Emccormick7@bloomberg.net; Susanne Walker in New York at swalker33@bloomberg.net To contact the editor responsible for this story: Dave Liedtka at dliedtka@bloomberg.net

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