Approaching the Ides of March, one could be forgiven for
thinking that U.S. fiscal solvency is facing untimely demise at
the hands of its own politicians, as Julius Caesar did over two
thousand years ago. Dueling budgets have been released by
the two Houses of Congress, with a yawning chasm between them in
terms of spending, taxes and priorities.
There is some reform and restructuring in each, but if there is a
reconciliation or compromise that is somewhere between the two
positions, U.S. deficit spending will still be on track to make
total federal debt escalate faster than Gross Domestic Product
(GDP) can grow.
As I wrote a year and a half ago, and then again last spring,
U.S. federal long bonds, or 'Treasurys,' have been in a secular
bull market since early 1981, probably the longest extended such
run in all history. That seems to have ended, as I
predicted it eventually would, in July of last year, 2012.
At that time, the ten-year Treasury' yield touched 1.47%, the
thirty-year yield at 2.47%.
Since then, with some back and forth, the rates have risen to
about 2.00% and 3.2%, respectively. This has already
inflicted some damage on investors' portfolios. As rates
are still very low, bond duration is still close to maturity,
and, thus, the hurt has been approximately 4% and 10%,
respectively, from the lowest points last summer. Thus, the
coupon payments to investors have not kept pace with the loss in
principal, let alone inflation, which is still around 2 - 3%.
The Effect on the Fed
The effect on U.S. federal government finances has not been
significant thus far. Most of the outstanding debt is
financed at the short end currently, so annual interest expense
is well under $200 billion. Thus, a small fraction of the
estimated total annual federal deficit of approximately $900
billion in the current fiscal year.
It is through the 'financial repression' of the U.S. Federal
Reserve Board, the Central Bank, that this facilitation of
borrowing -- originally instituted to help commercial and
consumer borrowers, especially mortgagors and lender -- has
allowed U.S. debt to grow fairly painlessly, so that its total
outstanding level exceeds 100% of GDP. This ratio is now
higher than that of other nations which have entered crisis mode,
and which have had to drastically slash spending and raise taxes.
This, in turn, lowered economic growth and expanded unemployment.
This year's annual federal deficit will exceed 6% of total GDP,
which is also higher than that of nearly all the European nations
that are undergoing restructuring -- Greece, Spain, Portugal,
Ireland and Italy -- let alone the others that are undertaking
austerity: Britain, France and Belgium. Such
indebtedness is unprecedented for a developed nation that is not
only in peacetime, but now in the fourth year of economic
recovery, and the third year of employment growth.
The Effect on Consumer Spending
Consumer spending, business hiring and general economic growth
are stoking credit demand. Population growth and recovery
in economic activity are spurring demand for gasoline, diesel
fuel, jet fuel and electric power. Both a severe drought
last year and normalized demand have increased food prices.
Consumer prices in general have been rising by over 2% per annum
for the past four years; spiking to over 3% on occasion.
Yet the Fed's benchmark 30- and 90-day Treasury bill rates remain
below 0.15% and 0.2%, respectively (at the most).
Meanwhile, the Fed continues to buy most of the new federal debt
that is issued, expanding its balance sheet with assets that have
begun to lose value, as long term interest rates climb.
Intermediate rates, that is, the ones in the five to ten-year
range, are also rising. The money that the Fed issues and
Washington takes in is, in turn, spent mainly on current
consumption and transfer payments for more current consumption,
fueling current and future potential inflation.
The Effect on Bond Investment
Long bond investors -- domestic and foreign -- are already
effectively demanding higher interest rates to compensate them
for declining principal values. More importantly, they are
declining purchasing power of the U.S. dollar, as inflation
erodes it. For foreign investors, the pain of a declining
dollar must be offset by a higher interest rate, or capital flows
into the U.S. to fund its borrowing will diminish, as they
already have to some extent.
Another factor is causing rates to rise: the U.S. economy is
finally recovering more strongly, and corporate profits are
rising beyond mere post-recession bounce-back. This is
spurring interest in equities, and the stock market indices are
rising to new record levels, drawing in more domestic and foreign
Simultaneously, commodity and oil and gas prices have backed off
highs of last year, and look set to remain tolerable, making
consumer confidence rise and moderating costs for business.
The energy and pipeline sectors are booming.
As business and equity investment have become more attractive,
and credit demand has risen, bonds have become less
attractive. Adding to this, house prices finally appear to
have bottomed out and are rising again, and new construction is
going on. Thus, real estate is once again more attractive;
another asset class that is more alluring than bonds.
With both economic growth and inflation now significant, and
credit growth rising, it is almost impossible to keep interest
rates at a low level. While there remain millions of people
who have been unemployed for years, the actual output gap in the
economy is nearly closed; that is, output has now recovered to
beyond the peak level of late 2007, early 2008.
Foreclosed properties, while still in considerable inventory, are
being sold off at a lower, slower pace by banks, bought up by
bargain-hunting investors, and rented out.
Private equity firms are finding plenty of attractive acquisition
candidates, as evidenced by the recent
) deals. Merger and acquisition activity has rebounded,
although initial public offerings remain subdued. Motor
vehicle sales and aircraft and rail equipment orders are robust.
Can/Will Spending Be Reined In?
Aside from the recent sequester action, which in the current
fiscal year only reduces the increase in discretionary outlays by
about $45 billion (essentially just cutting their growth rate in
half while letting entitlement spending continue to balloon),
there has been little done to rein in spending -- or raise
revenue, or sell assets -- to narrow the deficit other than the
payroll tax increase in January and the higher marginal rate on
Simplification and reform of personal and corporate income taxes
could greatly improve efficiency, lower compliance costs, and
bring in more revenue without increasing burdens on the
economy. However, none of the proposals put forth by the
main participants do enough to assure financial markets -- and
bond investors in particular -- that total federal debt growth
will slow down enough to allow the government to withstand a loss
in confidence that could occur at any time.
The present structural deficit of 5%, and interest expense of 1%,
cannot be ended by raising taxes alone. Such a tax hike
would cripple consumer and business spending and investment and
cause a severe recession, just as Greece and Spain are
experiencing. Also, the tax rate rises and deduction limits
that would be enacted to raise the revenue would not bring in the
predicted or forecast amount of revenue; they never do, because
the reduction in activity and income, and redirection of activity
to other activities and jurisdictions will be more than forecast.
In the short term, there seems to be little that can be done to
induce investors to continue to buy long bonds, or even
intermediate ones. Thus, rates seem likely, with some
gyrations, to continue to rise, putting federal finances further
Not all funding is possible using short-term borrowing.
Some long-bond financing is required. Most of Washington
appears to be determined to keep spending at current levels, and
to continue to increase that spending at least as fast as the
economy grows, with or without any increase in revenues that may
be agreed upon.
What's Bad… and How It Might Get Worse
Total U.S. federal debt is now close to $17 trillion. The
current average interest rate on it is around one percent.
Should the U.S. Treasury be compelled to refund expiring debt at
rates prevailing in a crisis of confidence, interest expense
could vastly expand, ballooning the deficit to over 10% of GDP,
which it just touched during the worst of the recession when
revenues collapsed and borrowing escalated.
For instance, just a more normal yield curve for this point in
the economic cycle, of 2.5% short-term rates, 3.5% intermediate,
and 4.5% long-bond rates would result in a rough quadrupling of
annual interest expense to nearly $700 billion in total.
Since most U.S. federal debt is actually very short term, a spike
in rates could bring even worse effects.
A full-fledged investor panic, such as Spain experienced, with a
much lower debt-to-GDP ratio, could bring spreads over comparable
German issues of four per cent or even more, along with a plunge
in tax revenues as the economy heads into recession. The
carnage in the bond markets would be dramatic.
Pension funds and investment managers would be forced to write
down their assets. Some active investors, including some
corporations, banks, investment banks, and other institutions,
would become technically insolvent, and unable to borrow, forcing
them into bankruptcy, as the real estate crisis did in 2007-8.
What You, the Investor, Should Do About This
At a minimum, individual and institutional investors should
curtail their borrowing at the seductively low prevailing
short-term interest rates of today to maintain or increase their
investments in short, medium, or long-term bonds of any kind, be
they federal, state, corporate, or high-yield. To be truly
prudent, they should not only end all such borrowing, or the
'carry trade,' but also cut back their fixed income exposure to
their fallback or minimum allocation level.
The slow, jagged climb of medium and long-term rates from their
lows of last year is not only not an aberration or abnormal, it
is entirely consistent with an economy that is recovering, and a
federal government that is not restraining its spending to
conform with its true, sustainable capacity. These rates
will keep moving up, and not always with the occasional reversion
downward, but more likely with sharp, destructive spikes upward
as financial markets return to more normal, risk-averting
characteristics, and out from under the artificial environment of
financial suppression enforced by the Fed.
A true budget deal that brings debt growth under control could
conceivably slow down this progress toward normality, but will
not allow investors to remain in low-rate nirvana for much
longer. The bond markets punished slow U.S. efforts to
regain control over spending in the mid-1990's. They could
so again, and sooner than expected. The warning signs are
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