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Since the dark days of March 2009, when it appeared that the US economy was falling off a cliff, there is a distinct sense of relief in official circles that financial Armageddon has been averted and that "green shoots" of US economic recovery are now being sighted. However, before allowing complacency to set in, the Obama Administration would do well to heed the clear warnings now emanating out of the US fixed income and dollar markets. Those markets are signaling loudly and clearly that all is not well with the long-term expansionary fiscal path on which the US economy is now embarked and that any incipient economic recovery could be aborted by higher long-term interest rates.

A central plank in the Obama economic recovery plan was to arrest the precipitous slide in US housing prices. Since not only was a continuing decline in home prices seen to increase bank losses and to complicate official efforts to assure the solvency of the US financial system, it was also seen to wreak further unwelcome damage on household balance sheets that would delay any eventual recovery in all important consumer spending.

With the US housing market still characterized by around 1 million units in excess housing inventories and with rapidly rising home foreclosures continuing to add to supply despite the Administration's modest efforts at foreclosure mitigation, the central hope for an arrest to falling home prices was to be a significant decline in mortgage interest rates. To that end, it was hoped that the Federal Reserve's March 2009 announcement that it would purchase up to US$1,450 billion in US mortgage-backed securities and US$300 billion in US Treasury bonds would succeed in lowering long-term borrowing rates and thereby spur housing demand.

Sadly for the prospect of any early stabilization in US home prices, the financial markets have proved unwilling to oblige the Administration's wish for lower long-term interest rates. Instead, financial markets have increasingly focused their attention on the disturbing long-run budgetary path on which the Obama Administration's highly expansionary spending plans, particularly in the areas of universal health coverage and green energy, have placed the US economy.

Underlining these disturbing budgetary trends are the estimates by the non-partisan Congressional Budget Office that the Obama Administration's longer run spending proposals would result in budget deficits remaining in excess of US$1 trillion a year over the next decade. They are also pointing to an approximate doubling in the US public debt to GDP ratio from 41 percent in 2008 to 82 percent by 2019.

The market's heightened concern about the budget's disturbing long-run trajectory, coupled with its mounting concerns that the Federal Reserve's "quantitative easing" policy might be tantamount to the monetization of the deficit, has resulted in long-run interest rates, including those on mortgages, rising to their highest level since last August. This heightens the prospects that US housing prices will continue to decline at the 15-20 percent annualized rate of the past year. At the same time, budget concerns have also placed the US dollar under renewed downward pressure, which has sparked a sharp rise in international oil prices that is hardly helpful for moderating inflationary expectations or for encouraging consumer spending.

Any further significant decline in US home price or any renewed slowing in the US economy would put at risk the Administration's relatively successful efforts to date to stabilize the US banking system. This would be particularly the case since Congress has made it quite clear that it does not wish to provide additional bank bail out money. It would also be the case in a context where US unemployment has already increased to 9.4 percent, making it all too likely that the worst case scenario of the government's bank stress test will be well exceeded.

One has to hope that the Administration heeds the market's warnings about the parlous state of the US public finances before higher long-term interest rates are allowed to inflict real damage on the nascent US economic recovery. In particular, one must hope that the Obama Administration, in concert with the US Congressional leadership, comes up in short order with a credible medium-term plan that would assure markets that spending cuts and tax revenue increases will be made that will restore the US budget to a path that can be financed in a non-inflationary manner that will not debase the US dollar.

Desmond Lachman is a resident fellow at AEI.