247Bull.com Editor: As mentioned in last week’s Market Wrap, government bonds have been in a multi-decade bull market since the autumn of 1981, which means that interest rates on government debt have been falling for more than 30 years. Now however, the bull market is nearing its end and the bursting of the sovereign debt bubble is one of the biggest threats to the wealth and savings of investors.
While Treasuries are said to have no default risk as the Federal Reserve (Fed) can always print money to pay off the debt, hidden risks might be lurking. As oxymoronic as it may sound, the biggest risk to the economy and the U.S. dollar might be, well, economic growth! Let us explain.
The U.S. government paid an average interest rate of 2.046% on the $11.0 trillion of Treasuries outstanding as of the end of November. Treasuries include Bills, Notes, Bonds and Treasury Inflation-Protected Securities (TIPS). At 2.046%, the cost of carrying the Treasury portfolio currently costs the government $225 billion per annum; about 6% of the federal budget was spent on servicing the national debt. 1
While total government debt has ballooned in recent years, the interest rate paid by the government on its debt has continued on its downward trend:
We only need to go back to the average interest rate paid in 2001, 6.19%, and the annual cost of servicing Treasuries would triple, paying more than Greece as a percentage of the budget. Not only would other government programs be crowded out, the debt service payments might likely be considered unsustainable. Except for the fact that, unlike Greece, the Fed can print its own money, diluting the value of the debt. In doing so, the debt could be nominally paid, although we would expect inflation to be substantially higher in such a scenario.
These numbers are no secret. Yet, absent of a gradual, yet orderly decline of the U.S. dollar over the years – with the occasional rally to make some investors believe the long-term decline of the U.S. dollar may be over – the markets do not appear overly concerned. Reasons the market aren’t particularly concerned include:
- The average interest rate continues to trend downward. That’s because maturing high-coupon Treasury securities are refinanced with new, lower yielding securities.
- Treasury Secretary Geithner has diligently lengthened the average duration of U.S. debt from about 4 years when he took office to currently over 5 years.
For the U.S. government, a longer duration suggests less vulnerability to a rise in interest rates, as it will take longer for a rise in borrowing costs to filter through to the average debt outstanding. The opposite is true for investors: the longer the average duration of a bond or a bond portfolio one holds, the greater the interest risk, i.e. the risk that the bonds fall in value as interest rates rise.
Operation Twist to hide interest risk
Debt management by the Treasury only tells part of the story on interest risk. When the Treasury publishes “debt held by the public,” it includes Treasuries purchased in the open market by the Fed. By engaging in “Operation Twist”, the Federal Reserve stepped onto Timothy Geithner’s turf, manipulating the average duration of debt held by the private sector. Notably, the private sector holds fewer longer-dated bonds, as the Fed has gobbled many of them up.
However, investors may still be exposed to substantial interest risk in their overall fixed income holdings as, in the search of yield, many have doubled down by seeking out longer dated and riskier securities.
The Fed, many are not aware of, employs amortized cost accounting, rather than marking its holdings to market, thus hiding potential losses should interest rates go up and its portfolio of Treasuries and Mortgage-Backed Securities (MBS) fall in value.
Quantitative easing to increase interest risk
Whenever there’s a warning that all the money created by the Federal Reserve is akin to printing money, some dismiss these concerns as the money created out of thin air to buy securities has not caused banks to lend, but park excess reserves back at the Federal Reserve. As of December 14, 2012, $1.4 trillion in excess reserves is parked at the Fed. Substantial interest risk might be baked into reserves:
Consider that the Fed has been paying about $80 billion in profits to the Treasury in recent years. Think of it this way: the more money the Fed “prints”, the more (Treasury & MBS) securities it buys, the more interest it earns. That’s why Fed Chair Bernanke brags that his policies have not cost taxpayers a cent, even if the activities may put the purchasing power of the currency at risk. Now, Bernanke has also claimed he could raise rates in 15 minutes. In our assessment, it’s most unlikely he would do so by selling long-dated securities; instead, in an effort to keep long-term rates low, the most likely scenario is that the Fed will pay a higher interest rate on reserves. Up until the financial crisis broke out, the Federal Reserve would have intervened in the Treasury market by buying and selling securities to move short-term interest rates. In the fall of 2008, the Fed was granted the authority by Congress to pay interest on reserves.
As interest rates rise, not only will Treasury pay more for debt it issues, it may also receive less from the Fed. Interest rates would have to rise to about 6% for the entire $80 billion in “profits” to be wiped out assuming a constant $1.5 trillion in reserve balances ($1.4 trillion in excess reserves and $0.1 trillion in required reserves that also receive interest); that assumes, the Fed does not grow its balance sheet in the interim (in an effort to generate more “profits” for the Fed) and would not reduce its payouts in the interim as a precaution because bonds held on the Fed’s books may be trading in the market at substantially lower levels.
Should interest rates move up, the Treasury may no longer be able to rely on the Fed to finance the deficit (while the Fed denies the purposes of its policies is to finance the deficit, the Fed is buying a trillion dollars in debt as the government is running a trillion dollar deficit).
Axel Merk | Merk Funds