Monday, March 12, 2012

Carry Trade

Uncle Sam's Teaser Rate
Low interest rates disguise the federal debt bomb.
WSJ Editorial, March 12, 2012

One business story these days is how companies are crashing the debt markets to raise money at today's bargain rates. The same goes for the world's biggest borrower, Uncle Sam, which is also quietly benefitting from historically low interest rates that cannot last. The latter deserves more attention because the next President and Congress are likely to be stuck paying the bill when rates inevitably rise.
First, a couple facts: the U.S. Treasury currently has $10.7 trillion in outstanding publicly-held debt, and more than $8 trillion of it must be repaid within the next seven years. More than $5 trillion falls due within the next 36 months.

This relatively short-term debt sheet is no accident. Like a subprime borrower opting for a low teaser rate, the government has structured its debt to keep current interest payments low. This is a political temptation for every Administration because it means lower budget deficits on its watch.

The Obama Administration has added close to $5 trillion to the U.S. debt. So it much prefers to finance all of this at a rate, say, of 0.3% in two-year notes than at 2% in 10-year notes. The nearby charts show how federal debt has soared during the Obama years, yet net federal interest payments are lower than they were in 2007 and lower than they were in nominal dollars even in 1997 when public debt was a mere $3.8 trillion. This year the debt is expected to reach $11.58 trillion.

The problem is that this disguises the magnitude of the debt threat and stores up trouble for future Presidents and taxpayers. And maybe not far in the future.

The Congressional Budget Office (CBO), for example, forecasts that in the period 2014-2017 the average rates on three-month Treasury bills will rise to 2% from less than 0.1% today. CBO expects average rates on 10-year Treasury notes to climb to 3.8%, from 2.03% now. CBO adds that every 100 basis-point rise in government borrowing costs over the next decade will trigger almost $1 trillion in new federal debt.

As of January 2012, taking into account all the various notes and bonds issued by the federal government to the public, Uncle Sam is paying an average interest rate of 2.24%. The government expects to spend in the neighborhood of $225 billion this year making interest payments.

That may seem like a large sum, and it is, but consider what happens if rates quickly rise back toward their historical norms. As recently as early 2007 the government was paying 5% on its debt, which is the average of the last two decades, though of course rates could always go higher. During the 1990s, the average was well above 6%.

If the government had to pay the 5% rate that it was offering before the financial crisis on today's debt, the annual interest payments would be $535 billion, twice CBO's projection for total federal spending on Medicaid this year. If Uncle Sam had to pay 6% on its debt, the annual interest payments of $642 billion would surpass total federal spending on Medicare, currently $484 billion. Such a radical change in budget math could trigger a political panic and intense pressure for tax increases, perhaps even for a European-style value-added tax.

Should Treasury be much more aggressive now in seeking to borrow for the long term at today's low rates? This would seem to be a sensible call, especially given that everyone except perhaps the Federal Reserve Board of Governors expects rates to rise.

Treasury says it is aware of the dangers and is acting on it. In a September 2010 letter to the Journal, Mary J. Miller, Treasury's assistant secretary for financial markets, reported that 55% of Treasury debt was maturing within three years and that this figure was declining. She added that Treasury planned to continue lengthening the average maturity of its debt.

Ms. Miller and her Treasury colleagues have been true to her word. Today, 52% of the debt is due within three years.

The problem is that, amid the astounding Obama-era increase in federal debt, Ms. Miller's letter arrived almost $2 trillion ago. So while short-term debt may be declining modestly as a percentage of Treasury paper, it's part of a much bigger debt pie.

Of course, Treasury can't decide entirely on its own to rely on longer-term financing. Investors watching the mounting Obama debt pile probably wouldn't agree to finance most of it for 30 years at a low rate. The risk of future rate increases or inflation are too great.

Not that we can tell how much private market demand exists for 30-year bonds anyway. The Federal Reserve is now among the largest buyers as it implements "Operation Twist" and other monetary adventures. 

This is a useful reminder that fiscal authorities aren't the only ones who will have trouble exiting from this era of profligate government. Sooner or later the Fed has to manage the withdrawal from its historically accommodative monetary policy. Even now many investors suspect that the Fed is keeping rates so low for so long in part to finance federal debt on easier terms.

If the economy gains steam—say, in a new Administration that reforms the tax code, cuts spending and reduces regulation—the Fed may have to raise rates to forestall inflation. But if it raises rates, interest payments on the debt will soar, the deficit may not fall from its Obama trillion-dollar levels, and pressure could build for a tax increase.

President Obama may not mind this outcome but Mitt Romney and Rick Santorum should, which is why they need to talk about this fiscal nitroglycerin that Mr. Obama and Fed Chairman Ben Bernanke have created. The two Republicans might also take a moment to wonder how much they really want this job. The next Presidential term may be spent trying to defuse the Obama debt bomb.

A version of this article appeared Mar. 12, 2012, on page A14 in some U.S. editions of The Wall Street Journal, with the headline: Uncle Sam's Teaser Rate.

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