talked about much, at least by mainstream analysts, but make no
mistake, it’s a time bomb, locked and loaded, and it’s
set to blow the U.S. government’s budget sky high.
That time bomb?
The interest cost on the government’s debt.
And what you
ask will light the fuse? The end of the 30-year bull market in U.S.
government debt, the end of record low interest rates.
In my opinion,
unless politicians decide to renege on the government’s obligations,
it’s not a matter of if, it’s a matter of when. And in
the end neither the U.S. government nor the Federal Reserve can
do anything about it.
preliminaries. At its most basic, the interest cost on the government’s
debt is determined by three factors:
- The outstanding
debt of the government
- The interest
rate paid on that debt
- The maturity
distribution of that debt
At the risk
of stating the obvious, higher levels of debt mean a higher interest
cost. Lower levels of debt mean a lower interest cost.
higher rates of interest on that debt mean a higher interest cost.
Lower rates of interest mean a lower interest cost.
shorter dated maturity distributions, leading to generally larger
and more immediate refinancing needs, means more exposure to interest
rates, and therefore, a higher interest cost when rates are rising
and a lower interest cost near when rates are falling. Longer dated
maturity distributions, leading to generally smaller and less immediate
refinancing needs, means less exposure to interest rates, and therefore,
a lower interest cost when rates are rising and a higher interest
cost when rates are falling.
preliminaries out of the way, let’s go straight to the numbers.
the 50-year trend in interest cost on U.S. government debt outstanding
through the government’s fiscal year 2009:
In 2009, the
government’s interest cost was about $383 trillion, 10.9% of
total government outlays. As a percent of total outlays, the government’s
interest cost is down 50% from the 1997 high of 22.2% and plumbing
lows not seen since the early 1970s.
a pretty healthy trend, right? And a relatively small part of the
government’s outlays to boot.
So what am
I worried about?
examine each interest cost determinant and see.
debt of the government. Charted below is the 50-year record
in U.S. government debt outstanding:
I would call
this high and rising levels of debt, wouldn’t you? At $12 trillion,
the U.S. government’s debt is at a 50-year high. What’s
more, with deficit spending largesse becoming more and more the
order of the day in Washington, first led by President Bush and
now led by President Obama, U.S. government debt has been growing
at an annual rate of 8.5% since 2000, with 2009 debt outstanding
up a whopping 19% from 2008. And as for the future, trillion dollar
deficits and trillion dollar borrowing needs are as far as the eye
can see. Not good.
rate paid on that debt. Now, take look at the 50-year record
in 1 year, 5 year and 10 year rates on U.S. government treasury
Rates are at
50-year lows and by the looks of it have nowhere to go but up. And
higher rates of interest do mean a higher interest cost, don’t
distribution of that debt. Finally, cast your eyes on the
average years to maturity on the government’s marketable debt:
at historical lows, at 4 years, the average maturity on the government’s
marketable debt is down 35% from the 2000 high and in the bottom
40% of this study. That means a whole heap of debt refinancing is
in the offing. In fact, the government must refinance a huge $2.6
trillion of its debt in fiscal 2010 and $4.7 trillion of its debt
in the next five years. This in addition to projected deficits conservatively
estimated by the Obama administration at $1.6 trillion in fiscal
2010 and a mega $5.7 trillion over the next 5 years.
for the sake of the U.S. government’s financial condition,
with these debt refinancings in the offing, interest rates better
stay at historical lows.
put this all together and see what we have:
Now do you
see what worries me, and should worry every U.S. treasury note buyer
in the world? That’s right, rising interest rates.
the importance of these historically low interest rates to the U.S.
government’s financial health, let’s have a look at the
ability of the government to cover its interest cost with government
receipts, in financial circles termed the coverage ratio:
low interest rates, the ability of the government to cover its interest
cost is not exactly at all time highs, is it?
To size the
scope of the problem, let’s have a look at the government’s
interest cost at interest rates more in keeping with history:
On the positive
side, it’s apparent what these low interest rates have meant
to the U.S. government. Despite an 8.5% annual growth rate in government
debt since 2000, the government has been able to increase its coverage
ratio from 2.8 to 5.5. The reason, a 52% fall in the composite interest
rate it pays on its debt, from 6.25% to 3.22%. Unfortunately, with
interest rates having practically nowhere to go but up, that may
be as good as it gets.
interest rates simply return to the long-term average rate in this
study (a good long-term mean proxy as it spans one full bear and
one full bull market), we are looking and an interest cost of $738
billion on 2009 government debt levels, 92% higher than in 2009.
That would put the government’s ability to pay for this cost,
as measured by the ratio of receipts to interest cost, at 2.9 against
a current ratio of 5.5. Said differently, 35% of the government’s
receipts would be going to pay the interest on the government’s
And if interest
rates were to overshoot that long-term average rate and return to
the rates seen during the inflationary 1970s and early 1980s, we
are looking at an interest cost of a huge $1.2 trillion, 219% higher
than in 2009 and giving us a lowly coverage ratio of 1.7. That would
mean near 60% of the government’s receipts would be going to
pay the interest on the government’s debt.
In other words,
not much left to spend on anything else.
Now, with projected
government deficits in the trillions for years to come and according
to some reputable sources as much as $100 trillion in unfunded liabilities
yet to be transformed into even more spending and in turn into even
more government debt, we could be looking at a virtual explosion
in the government’s interest cost.
Using the Obama
administration’s own conservative debt projections, take a
look at what the government’s interest cost could look like
in 1 year, 3 year and 5 year’s time:
Even with conservative
debt projections and simply a return to long-term interest rate
averages, we are looking at a coverage ratio of 1.8 in 2014 on 2009
tax receipts. That’s 57% of the government’s receipts
going to pay the interest on the government’s debt. And if
we see a return of the inflationary 1970s and early 1980s, a startling
91% of the government’s receipts will be going to pay the interest
on the government’s debt.
Yes, I know,
I haven’t allowed for any growth in government receipts. But
I can safely say, raising tax rates and growing the size of government,
like the Obama administration currently plans, is not going to help
grow the private economy; you know, the people that have to pay
for all this stuff. And as a result, it will only hamper the ability
of the government to grow its tax receipts, possibly even enlarging
Obama’s already huge deficit and debt projections.
OK, you say.
Yes, the U.S. government is exposed to rising interest rates. But
the Federal Reserve, isn’t it committed to keeping interest
rates low, as it loves to say for an extended period of time?
Low rates mean problem solved, right?
is exactly what Bernanke and the Federal Reserve, along with the
U.S. Treasury, would like you to think. And it is indeed what they
are trying to do. The question is, how long can they do it? Certainly
not forever, for the market is bigger than even these mighty institutions.
In my opinion,
when it comes to keeping interest rates at bay, the Federal Reserve
and the U.S. Treasury are increasingly on borrowed time.
appeared on True/Slant.
Pollaro [send him mail]
is a retired Investment Banking professional, most recently Chief
Operating Officer for the Bank’s Cash Equity Trading Division. He
is a passionate free market economist in the Austrian School tradition,
a great admirer of the US founding fathers Thomas Jefferson and
James Madison and a private investor. He is a columnist for True/Slant