Financial markets function to discount the future. Usually, by the time you read about something in the newspaper, financial market pricing has already “discounted” that event weeks, months, or perhaps even years before it hits the front page and becomes evident to everyone else. That’s what it means to “speculate.”
The whole world is beginning to seriously speculate that the Treasury is becoming a deadbeat borrower. Normally, such speculation would be expressed as a higher cost for borrowing, meaning higher interest rates on treasuries, coupled with a reluctance by lenders to offer long-term financing. If you have money to lend, why would you risk it by lending long term when you would be exposed to less risk by lending short term? The risk for lending long term to the Treasury is that there is more time for something bad to happen like inflation, a currency collapse or even default. As Will Rogers once said, “I ain’t so much worried about the return on my money as the return of my money.”
So, Treasury bond market speculators have a problem. The Federal Reserve’s current monetary policy is unintentionally manipulating the market’s willingness to express a true perception of the growing credit deterioration of the U.S. government’s balance sheet.
Specifically, lenders to the Treasury would prefer to lend short term (under one year) rather than long term (beyond five years). However, the Fed has pegged interest rates in the short end of the treasury market at near zero percent. Lenders willing to lend money short are getting no return. Beyond five years, where Fed policy influence is significantly less, the return for a lender is much better at 3.5 percent or higher.
So here is the problem: The market wants to lend short, but that desire doesn’t get paid. The market is reluctant to lend long, but that reluctance is rewarded with a higher return. So, what happens when the Fed begins taking its foot off the monetary accelerator and short rates in the treasury market begin rising? The Fed will almost certainly begin raising short rates in the next six to 12 months.
Currently, about 30 percent (c. $4 trillion) of total outstanding Treasury debt matures in less than one year. About 55 percent (c. $7.5 trillion) of the total national debt matures in less than three years. If the Treasury currently matures $4 trillion of debt each year, and, in addition, runs an annual deficit of $1.4 trillion, then the total annual borrowing requirement will be $5.4 trillion. What happens if the 55 percent of the debt that matures in three years decides to migrate to a maturity of less than one year as reluctant longer-term lending gives way to preferred short-term lending, encouraged by an inevitable shift in Fed policy to raise short-term interest rates?
In that case, the total annual borrowing requirement (maturing debt plus the deficit) becomes a gigantic $8.9 trillion. Each year’s maturing debt has to be “rolled” (new debt sold to replace that which is maturing) to the next year (at least), and each year’s new borrowing need (the deficit) has to find buyers from the same pool of lenders. The annual maturing debt “roll,” plus the annual government deficit, make up the total annual borrowing requirement for the Treasury.
How gigantic is $8.9 trillion? It’s approximately the combined size of the second and third largest GDPs on the planet, Japan and China, combined. It’s also approximately the sum of the GDPs of Germany, France, England, and Brazil. U.S. Treasury debt financing, which already depends on the kindness of strangers, will become even more so. And each year the world’s lenders (the notorious “bond vigilantes”) will get to decide if they want to finance over half of the entire maturing Treasury debt structure.
Bottom line, in the next year or two, interest expense as a percentage of federal government’s receipts could easily explode to the upside and exceed 20 percent (the Congressional Budget Office’s projection for the current year is 9.5 percent) as Fed policy change translates immediately into higher interest expense on what might be approximately 55 percent of the Treasury’s total outstanding debt. Fed monetary policy will then become hostage to the combined annual maturing debt “roll” and deficit.
At that point, the Fed’s predicament will be that it won’t be able raise interest rates to stop inflation or defend the U.S. dollar for fear of what it will cost the Treasury in additional interest expense. Lenders, both foreign and domestic, would begin to speculate that the Treasury could soon be caught in a borrowing death spiral (funding both maturing debt and deficit increasingly driven higher by rising interest expense). These lenders would be very easily tempted to withdraw liquidity from the Treasury bond market (the dreaded buyers strike). That, in turn, will force the Fed to simply print the money in order to provide the required financing. The money printing would then easily translate into a serious inflation (hyperinflation) and a currency collapse.
Anyone want to “speculate” on an alternative happy ending to this story?
Realists may wish to ask a more profound question when confronted with the shocking size of America’s annual debt “roll” and deficit: Where is the current leadership in Washington taking our nation?