In the spring of 1993, the U.S.economy was in a funk. Bill
Clinton had just become president with hopes of reviving a moribund
economy that was growing just 0.7% on a year-over year-basis at
that time. Well, the next few quarters showed modest signs of life
as the economy started growing at a 2% pace.
And then, boom. The economy really built a head of steam, rising
by an average of 5% in the final quarter of 1993 and the first two
quarters of 1994.
Thebond market quickly responded, as bond traders began to
demand higher rates in an economy that was quickly absorbing any
remaining slack. Just look at what happened to yields on the
10-yearTreasury bill (T- Bill) as 1994 progressed.
Of course, few are thinking about lofty bond yields these days.
Today's 10-year T-bill yields just 1.7%. That's the result of a
prolonged economic slump that shows no signs of letting up. But
what if our long economic malaise is about to end? What if the
housing market and other factors start to finally boost the U.S.
economy? Indeed, we're not all that far away from 3%gross domestic
) growth, which could come as soon as 2013 or 2014, if the stars
start to align.
Frankly, increasingly robust growth could spell real trouble.
But not for stocks, which would still look reasonably priced, even
if interest rates were a few percentage points higher than they are
now. And not for Corporate America, which has already locked in
much of itslong-term debt at ultra-low rates. We're talking about
real trouble for the U.S. government, perhaps one that could
trigger a crisis few are talking about.
Borrow now, worry later
In some respects, policy makers have benefited from a remarkable
stroke of good luck. Even though the amount ofmoney the U.S.
government owes has been rising quickly, interest payments on that
debt have barely budged. Let's take a look at the past eight years'
worth of data.
No matter how you slice it, $360 billion in annual interest
expenses is a massive number. But if the government's borrowing
costs were the same amount in 2005, then that figure could balloon
to $682 billion. This means the government could work feverishly to
slice our national debt in half (which means taxing the economy a
cumulative $7 trillion more than it spends), and the current rate
of interest payments wouldn't change -- if interest rates returned
to 2005 levels.
For a bit of context, the $360 billion the government now spends
on interest payments is more than the combined budget of these five
key government agencies:
Now, if rates rose and the annual interest payments swelled to
$682 billion, then the following federal agencies would see their
funding crowded out:
Of course, there's no plan to simply eliminate these programs.
But each one could face serious cutbacks if rising interest rates
lead to a hike in interest expenses.
Now you can begin to see why Federal Reserve ChairmanBen
Bernanke is doing everything in his power to force rates down. His
ostensible goal is to boost economic activity through benefits that
would lower corporate and consumer borrowing costs. But his real
goal is to help Uncle Sam forestall a major interest-rate
Yet at the same time, Bernanke and everyone else would like to
see the economy get healthier. A rising economy makes the budget
math that much easier as government social safety commitments
shrink and government tax receipts rise (thanks to expanded
But as we saw in 1994, a firmer economy has the unavoidable
effect of firmer interest rates. Analysts at Merrill Lynch say we
are already seeing a repeat of the 1993-1994 era begin to play out.
Back in 1993, investors were snapping upyield plays such asreal
estate investment Trusts (REITs), emerging-market debt and other
income-producinginvestments . As a result, there was ample excess
global liquidity pushing down yields in manyasset classes.
Fast forward to 2012 and "investors have poured money into any
bond anywhere that offers acoupon ," noted analysts at Merrill
Lynch, and they think that "the resemblance between asset price
returns in 1993 and 2012 is almost uncanny."
A closing window
Perhaps the biggest shame of the modern U.S. fiscal era is the
government's decision to keep rolling over its debt in fairly
short-term instruments. In an ideal world, all of the government
debt that has been issued during the past few years would have been
in 20- or even 30-yearbonds . That would remove a great deal of
interest rate risk that the government faces. Instead, the vast
majority of government borrowings have been in one or two-year debt
instruments, which means Uncle Samwill be rolling over trillions of
dollars in debt from 2013 to 2015 and beyond. That's no problem if
rates stay low, but it will create a fiscal nightmare if that debt
gets rolled over at ever-higher rates.
Risks to Consider:
As an upside risk, investors have a remarkable ability to shrug
off future concerns if the next few quarters look OK, so don't be
surprised to see a cork-popping rally when the "fiscal cliff"
agreement is finalized.
Action to Take -->
An increasingly bleak interest rate picture for the U.S. government
does not necessarily spell trouble for U.S. stocks. Many companies
are in remarkably strong financial shape, and if they are operating
in global industries or in economically-insensitive parts of the
U.S. economy, then there's no reason their revenue streams should
But for any companies that rely on the largesse of the U.S.
government -- from defense contractors and for-profit educators, to
technology providers -- a higher level of interest expense will
crowd out thefunds available for any other programs. States, for
example, count on one-third of their revenue base from Washington,
and it looks increasingly inevitable that federal funding will be
reduced. That couldmean higher state and localtaxes , or smaller
staffed police departments and larger classroom sizes at
This also explains why investors need to pay close attention to
the government's financial picture long after a "fiscal cliff"
resolution is made." Such an agreement would addressissues for
2013, and may even forge a path to a balanced budget. But Congress
still needs to tackle the actual reduction of the more than $15
trillion in current long-term debt. And the only way for that to
happen is for the government to run surpluses, something nobody in
Washington can even contemplate right now.
-- David Sterman
David Sterman does not personally hold positions in any
securities mentioned in this article. StreetAuthority LLC does not
hold positions in any securities mentioned in this article.
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