Debt Before Dishonor: Financial Crisis Aversion Watch (part 3)
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 investors.
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 Dell (DELL) and Heinz (HNZ) 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 top earners.
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 at risk.
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 evident.
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