Consider the following numbers: 2.2, 62.8, 454, 5.9. Drawing a blank? Not to worry. They don’t mean much on their own. Now consider them in context:
1) 2.2 percent is the average interest rate on the US Treasury’s marketable and non-marketable debt (February data).
2) 62.8 months is the average maturity of the Treasury’s marketable debt (fourth quarter 2011).
3) $454 billion (R3.5 trillion) is the interest expense on publicly held debt in fiscal 2011, which ended September 30.
4) $5.9 trillion is the amount of debt coming due in the next five years.
For the moment, numbers 1 and 2 are helping number 3 and creating a big problem for number 4. Unless the Treasury does something about number 2, numbers 1 and 3 will become liabilities while number 4 has the potential to provoke a crisis.
In plain English, the Treasury’s reliance on short-term financing serves a dual purpose, neither of which is beneficial in the long run. First, it helps conceal the depth of the nation’s structural imbalances: the difference between what it spends and what it collects in taxes. Second, it puts the US in the precarious position of having to roll over 71 percent of its privately held marketable debt in the next five years – probably at higher interest rates.
First among equals
And that’s a problem. The US is more dependent on short-term funding than many of Europe’s highly indebted countries, including Greece, Spain and Portugal, according to Lawrence Goodman, the president of the Center for Financial Stability (CFS), a non-partisan New York think tank focusing on financial markets.
The US may have had a lot more debt in relation to the size of its economy following World War II, but the structure was much more favourable, with 41 percent maturing in less than five years, 31 percent in five-to-10 years and 21 percent in 10 years or more, according to CFS data. Today, only 10 percent of the public debt matures outside of a decade.
Based on the current structure, a 1 percentage-point increase in the average interest rate will add $88bn to the Treasury’s interest payments this year alone, Goodman says.
If market interest rates were to return to more normal levels, well, you do the math.
Some economists have cited the Treasury’s ability to borrow all it wants at 2 percent as an argument for more fiscal stimulus. Why not, as long as it’s cheap?
Goodman says the size of the deficit – 8.2 percent of gross domestic product (GDP) – or the debt – 67.7 percent of GDP – is only part of the problem. The bigger threat is rollover risk: “the same thing that got countries from Portugal to Argentina to Greece into trouble”, he says. “It’s the repayment of principal that often provides the catalyst for a market event or a crisis.”
The US is unlikely to go from all-you-want-at-2-percent to basket-case overnight. That said, policymakers would be wise to view recent market volatility as a taste of things to come.
Talking to Goodman, I was reminded of the Treasury’s standard sales pitch before quarterly refunding operations during periods of rising yields. Some undersecretary for domestic finance would be dispatched to tell us that Treasury expected to have no trouble selling its debt.
I had an equally standard response: At what price?
That seems particularly relevant today. The Federal Reserve purchased 61 percent of the net Treasury issuance last year, according to the bank’s quarterly flow-of-funds report. That’s masking the decline in demand from everyone else, including banks, mutual funds, corporations and individuals, Goodman says.
Of course, Fed chairman Ben Bernanke might look at the same numbers and see them as a sign of success. His stated goal in buying bonds is to lower Treasury yields and push investors into riskier assets.
Free to borrow
Then there’s the distortion in the relative value of stocks versus bonds to worry about. Using the 10-year cyclically adjusted price-earnings ratio and the inverse of the 10-year Treasury yield, Goodman says the relationship hasn’t been this out of whack since 1962.
The Treasury isn’t unaware of the rollover risk. At the same time, it’s trying to accommodate the increased demand for “high-quality liquid assets”, such as Treasury bills, as required under new international capital-and-liquidity standards, says Lou Crandall, the chief economist at Wrightson ICAP in Jersey City, New Jersey.
In fact, when Treasury bills carry a negative yield – when investors are paying the government to hold their money for three, six or 12 months – borrowing “more is better”, Crandall says.
Still, the dangers are very real and were highlighted by Bernanke himself last week in the second of four lectures to students at George Washington University.
Explaining why the decline in house prices had a greater impact than the drop in equity prices less than a decade earlier, Bernanke talked about “vulnerabilities” in the financial system. Too much debt was one; a reliance on short-term funding was another.
I doubt he had the Treasury in mind when he was explaining how the subprime debacle morphed into a global financial crisis, but the US government would be wise to heed his advice.
Currently, its demand on the credit markets for annual interest and principal payments is equivalent to 25 percent of GDP, Goodman says, 10 percentage points higher than the norm.
That’s real money. And with the federal budget deficit projected to top $1 trillion for the fourth year running, the funding pressure is bound to increase.
So the next time you hear someone say the Treasury can borrow all it wants at 2 percent, tell them, that’s true – until it can’t. – Bloomberg