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.
DELL INC (DELL): Free Stock Analysis Report
HEINZ (HJ) CO (HNZ): Free Stock Analysis Report
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