Saturday, March 02, 2013

The US Treasury's Ability to Borrow is Already Threatened

This is in response to a comment that stated that there would be no change in congressional behavior until our ability to borrow was threatened.  That's true, but at the same time missing a very significant point.

Our ability to borrow is already threatened. You just don't notice it if you only pay attention to interest rates on US Treasuries. In years passed, the interest rates on treasuries was a signal about the willingness of investors to loan money to the US Federal government. When investors perceived greater risk of default, they demanded a higher interest rate.

The current US Treasury market is a different beast though, and until you see what is going on in it the interest rates will be a false signal.

The Federal Reserve has stated that they will enforce a ZIRP (Zero Interest Rate Policy) on the short end of the curve -- through 2015. For an investor, that means the interest rate risk on Treasuries with a maturation of 3 years or less is essentially nill. Well, the risk is confined to the investor's confidence in the Federal Reserve's ability to enforce ZIRP for that time frame. Since the Fed has demonstrated a willingness to be the buyer of first, last, and only resort for short-dated Treasuries, that risk is understood to be effectively non-existent. See the video linked below to observe the Fed's ability to come in and just flat own the marginal (and then some) portion of the short end of the Treasury curve.

A quick aside on "interest rate risk." This is the risk that you would buy a Treasury yielding X% today, and at some point before it matures, the market interest rate for that duration of Treasury would be X+Y%. This isn't a concern about repayment, it is a concern that you will be holding a Treasury that isn't very marketable (since buyers could go purchase a better paying Treasury than the one you are trying to sell).

The net result of ZIRP on the short-end of the Treasury market is that investors see, rightly, that any Treasury with a duration less than the ZIRP time frame is just as liquid and secure as cash. In fact, it is just a little bit better than cash, as measured by the tiny little bit of interest it pays.

So that's the short-end of the Treasury market. There is zero signal in these interest rates about investor's confidence in the US Federal government. Instead, the signal in these interest rates is entirely about the Federal Reserve bank's (a privately owned, Federally chartered, at-arms-length-if-at-all Federally managed bank) ability to control the short end of the yield curve. They demonstrated their ability to crush this end of the curve, and the bond market investors believe them.

What about the long end? What signals are the interest rates on the 10 year and 30 year Treasuries sending? To make sense of this, again, we have to look at what is going on in the market.

And, what is going on in the market is basically scary as hell. The Federal Reserve bank has become the dominant buyer of all net new long-dated US Treasuries. Prices are set at the margin, and the Federal Reserve's long-dated Treasury holdings have become anything but marginal in the past year or so. The movie linked at the bottom shows how the Federal Reserve first effectively wiped out the short-end of the curve (turning the 3yr and shorter into cash-equivalents), and now how it has moved into the long-end of the curve to drive those rates down. The Federal Reserve is spending $45 billion per month to control the long end of the curve.

But, it's worse than that. Bond investors need yield. They need yield because they are insurance funds and the core of large retirement programs (pensions, and Social Security). They need returns that are stable over long periods of time, otherwise their ability to meet their obligations becomes much, much more difficult. One place that these investors sought yield was in the Mortgage Backed Security (MBS) market. The Federal Reserve has been crushing interest rates in that market too, soaking up an enormous swath of net new issuance -- to the tune of $40 billion each month.

So, here is the question that is worth pondering. What would long-term interest rates be if the Federal Reserve were not currently spending $85 billion each month to keep them contained?

When you think about that, remember that bond investors are looking for stable yield, and that the risk associated with all bonds can be translated into interest rates (by just lumping the cost of a companion Credit Default Swap (CDS) insurance contract into the cost of riskier borrowers).

To help consider the impact of that $85 billion in proper perspective: the US Federal government is currently borrowing about $100 billion per month.

And that is why I moved my family out of the city and to rural Idaho almost 2 years ago. The US Federal government is only able to cheaply fund about 15% of its deficit. There is, effectively, no functioning long-dated debt market in the US (and most of the world for that matter). All of this sequester fighting is over $86 billion from now through the end of September. Can you even imagine the disaster that cutting nearly that much each month would mean?

That last sentence might make you want to retort something like, "but investors, real investors, will buy Treasuries when interest rates rise." And you would be right. But, to think that would make things OK is to ignore the giant "roll risk" facing the US Federal Government.

What is "roll risk?" Roll risk is the risk a borrower faces when they take out a loan but are unable to repay when the loan comes due. If that happens, the borrower will then need to go borrow new money in order to pay off the old loan. This is called rolling the note. Roll risk is the risk that you will have to roll a note in a market with a higher interest rate than the original loan you are repaying. When that happens, you go deeper in debt in order to pay off the old debt. It's a bit like paying off your low-interest-rate car loan by using your higher-interest-rate credit card.

The US Federal government is facing this risk in spades. Which makes sense, interest rates have been pushed down by the Federal Reserve for at least the past decade, and aggressively so for the past half-decade. At the same time, the total US Federal debt has ballooned. Unless tax revenue suddenly spikes like mad and revenues exceed expenditures, the US Treasury dept. is going to be stuck rolling notes as these US Treasury bonds come due. On a fiscal year basis (Oct 1 - Sept 30), the US Treasury has gotten deeper in debt every single year for the past 30 years or so. On a net basis, they have NEVER not "rolled the note".

So, if interest rates do rise enough that real investors are buying the bulk of US Treasury issuance so that interest rates again have an actual signal in them (other than the signal being that the Federal Reserve is going to keep rates low), the US Federal government gets crushed by roll risk as they repay super-low interest rate US Treasury securities by selling much-higher interest rate securities.

How big of a deal is that roll risk. Well, if the interest rates go back to their long term ranges, then the US Treasury is looking at about $900 billion per YEAR in interest expenses. That's a brutal increase from the $359 billion of last year. An extra $45 billion each month.

This is why nations tend to collapse when their debt goes over 100% of their GDP. They get stuck. They can't afford for interest rates to increase. And, the portions of their economy that have to operate with something approaching long-dated financial planning simply can't due to the inability to save money without incurring real loss. When the central bank kicks and pushes and goads the citizens into spend it now, don't save it unless you want to lose it thinking, the long-term economic viability of a nation just sort of evaporates.

At this point in time, I'm not sure that our situation is recoverable. If it is, it's going to hurt like hell. If it isn't, it's going to hurt like even more hell. If I were you, I would be looking into how my family and my loved ones are going to get through this. Either that, or finding an actual coherent explanation for how the wheels are going to avoid coming off the bus. I've been looking for that explanation for 5 years now and haven't found it.


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