- Michael Pollaro
- The outstanding debt of the government
- The interest rate paid on that debt
- The maturity distribution of that debt
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:
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.
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.