• Interest on U.S. Government Debt, a Brewing Time Bomb

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    It’s not
    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.

    First, some
    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.

    Similarly,
    higher rates of interest on that debt mean a higher interest cost.
    Lower rates of interest mean a lower interest cost.

    And finally,
    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.

    With those
    preliminaries out of the way, let’s go straight to the numbers.

    Here’s
    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.

    Looks like
    a pretty healthy trend, right? And a relatively small part of the
    government’s outlays to boot.

    So what am
    I worried about?

    Let’s
    examine each interest cost determinant and see.

    The outstanding
    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.

    The interest
    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
    notes:

    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
    they?

    The maturity
    distribution of that debt.
    Finally, cast your eyes on the
    average years to maturity on the government’s marketable debt:

    Although not
    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.

    Simply said,
    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.

    Let’s
    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.

    To underscore
    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:

    Despite historically
    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.

    Observe, if
    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
    debt.

    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.

    Ouch!

    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?

    Well, that
    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.

    This originally
    appeared on True/Slant.

    February
    20, 2010

    Michael
    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
    magazine.

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