Surprising as it may seem given the headlines, real interest rates (net of inflation) are not high (I’m using the ten-year Treasury as benchmark), but they are quite a bit higher than they have been. The September average was some 1.7 percent (it’s around that now). That’s well below the levels seen in the 1990s, as are nominal rates. The 1990s economy is generally fairly fondly remembered. Such numbers need not be the end of the world.
But what’s different now is that rates are rising after a long period in which they were kept artificially low. It was a time when many borrowers took out cheap loans that, as their rates eventually move up (or the loans have to be refinanced), will come to seem not so cheap after all. That will have painful consequences for those borrowers. It’s also bad news for the owners of assets that have seen valuations pushed up on the back of cheap money. Some borrowers will be in a double fix. The cost of their indebtedness has increased, while the value of the asset they bought with that borrowed money is falling.
There is also the small matter of the U.S. government, which massively increased its borrowing when money was extraordinarily cheap, but, for whatever reason, did not take much advantage of the lower rates to lock in low borrowing costs. The average maturity of government debt can be distorted by a whole number of factors (for example, in a crisis, the government may issue a whole lot of short-term debt, distorting the average), but the fact that, according to this report from the Peterson Institute, the average maturity of Treasury debt is 73 months, suggests that an opportunity has been missed, even if 73 months is ten months longer than the historical average over the last 20 years (it should be noted that, for technical reasons the “average” figure overstates the real maturity).
It’s a little unfair but not totally irrelevant to note that Argentina (Argentina!) issued a 100-year bond in 2017 (yielding 7.9 percent), and Austria issued a couple, one in 2017 and another in 2020 (the latter yielded 0.85 percent). These bonds were in hot demand (don’t ask how they have done since), and the U.S. could surely have gone down a similar route.
Here’s economist John Cochrane, writing in June 2020:
Sure demand is high for US government debt, rates are low, and there is no inflation. But don’t count on trends to continue just because they are trends. How long does high demand last? Ask Greece. Ask an airline.
Third, for this reason, I argue the US should quickly move its debt to extremely long maturities. The best are perpetuities — bonds that pay a fixed coupon forever, and have no principal payment. When the day of surpluses arrives, the government repurchases them at market prices. By replacing 300 ore more separate government bonds with three (fixed rate, floating rate, and indexed perpetuities), treasury markets would be much more liquid. Perpetuities never need to be rolled over. As you can imagine the big dealer banks hate the idea, and then wander off to reasons that make MMT sound like bells of clarity. That they would lose the opportunity to earn the bid/ask spread off the entire stock of US treasury debt as it is rolled over might just contribute.
But we don’t have to wait for perpetuities. 30 year bonds would be a good start. 50 year bonds better. The treasury could tomorrow swap floating for fixed payments.
Then we would be like the family that got the 30 year fixed mortgage. Rates go up? We don’t care. By funding long, the US could eliminate the possibility of a debt crisis, a rollover crisis, a sharp inflation for a generation. [Emphasis in original]
An opportunity, expensively missed.
So back to what’s happening now.
Rates continue to rise (the ten-year is now around 4.7 percent, compared with about 0.8 or 0.9 in late 2020, or, if you’d prefer a pre-Covid number, 1.7 percent in late 2019).
My suspicion is that, even if only intuitively, continuing inflation fears still account for some of what’s going on, but Kelly Evans, writing for CNBC, points the finger at another culprit, the growing government debt load and the cost of servicing it. It’s hard to imagine that investors are unaware of this issue.
Evans (emphasis hers):
The biggest change since April, in terms of what could affect “real” yields, is not the U.S. long-term productivity picture, or demographics, or de-globalization, or what have you. It’s the sharp increase in the budget deficit. Back in April, for instance, Goldman expected this year’s deficit to be $1.6 trillion–already a hefty sum. But it actually came in at $2 trillion, and would have been $2.3 trillion if not for the Supreme Court’s last-minute cancellation of the president’s student loan forgiveness plan.
And the problem is, there’s no one-off “reason” for that sky-high figure, which is a doubling from last year and, at 7.4% of GDP, the largest non-emergency deficit we’ve ever run. Revenues have fallen back to historical averages after a surge in the two previous years, so that’s not helping. But spending meanwhile remains about three points higher than it was pre-pandemic, and for a wide variety of reasons, from higher Medicare and Social Security payments, to a lack of Fed remittances, to FDIC spending on the bank bailouts, and so forth.
Do you see anything in there that looks easy to fix? I don’t. Markets don’t, either. Entitlement reform is literally the hardest thing this country might have to undertake . . .
Not helping is the fact that interest costs themselves are now the biggest driver of the budget deficit going forward. That’s right; interest rates have been rising because the fiscal picture is worse than expected . . . and the more that rates rise, the worse the deficit will get, in what’s been termed a “fiscal doom loop.”
More than half of the budget deficit in the coming years is expected to result from higher interest payments. CBO thinks the deficit will average about 6% of GDP through 2033, with 3.1 points of that from interest payments on the debt. As a result, deficits will be running nearly twice as high as the historical average of 3.6%. And we haven’t seen deficits of more than 5.5% for more than five years in a row since at least 1930, they note.
We are running around a 3% primary deficit right now (meaning, ex-interest payments), but we need to get that down to only about 0.5% to stabilize our current debt-to-GDP ratio, according to Goldman’s Alec Phillips. Unfortunately, CBO is projecting 3% primary deficits for the next decade, meaning, if we don’t quickly close the gap between spending and revenues, the debt load will keep growing, and interest costs will keep on rising, and the deficit will thus stay elevated, which grows the debt load even more.
Closing that gap will not be easy, but the one thing that we can be sure of is that this process won’t be quick, which makes the “ahem” in Evans’s closing paragraph all the more worth noting.
Either D.C. needs to enact difficult policy changes that will drastically reduce the amount of future Treasuries coming onto the market, or a major new buyer (ahem, central banks?) needs to re-emerge.
And if the Fed is included in “central banks,” what would that do to inflation expectations?