The Year Ahead in Rates

As I look into 2011, I wonder when the US will have their Greek moment, when lenders walk away from our debt, and yields go exponentially higher. Without trying to sound like a Cassandra, I believe that the US will reach a tipping point with its debt rates and interest burden during this decade. We will not get out of this debt spiral without a severe change in the way the US government operates, and in all likelihood, this will be a crisis of a magnitude we have not seen in our lives. 


In last Wednesday’s blog, I did a hypothetical back of the envelope to explain why rising interest rates will sink the fiscal position of the US. I started off with the assumption that the government rolls its debt over at an average rate of 1%, but then went on to multiply the government’s debt times the rate to come up with an expected interest expense of $140 billion ($14 trillion times 1%). A reader reminded me that the actual debt expense for the US is around $400 billion, which reflects a legacy of higher interest rates. Here is a brief summary of the history of the US’s debt level and interest expenses:


Time      US Debt   Int Rate  Debt Costs  (all $s are in trillions)

Nov-06      $8.66    5.03%    $0.44

Nov-07      $9.15    4.91%    $0.45       Int Rate is the average for the US

Nov-08     $10.66    3.96%    $0.42

Nov-09     $12.11    3.32%    $0.40

Nov-10     $13.85    3.01%    $0.42


As the data shows, falling interest rates have allowed the US government to continuing borrowing at lower and lower rates, which has offset the fact that our debt is rising at a pace of $1.5 trillion a year. This is just remarkable, and has given rise to a feeling of invincibility on the part of our government, which thinks they can borrow from now to eternity. Looking forward, I present three scenarios:


Scenario 1: Rates stay low

Nov-11     $15.35    2.70%    $0.41

Nov-12     $16.85    2.39%    $0.40

Nov-13     $18.35    2.39%    $0.44


Scenario 2: Rates go higher

Nov-11     $15.35     3.20%   $0.49

Nov-12     $16.85     3.60%   $0.61

Nov-13     $18.35     4.00%   $0.73


Scenario 3: Rates go much higher

Nov-11     $15.35     3.40%   $0.52

Nov-12     $16.85     4.00%   $0.67

Nov-13     $18.35     4.50%   $0.83


Even if the world continues to fund the US government at current record low rates, the accumulation of more debt will offset any benefit derived from the fact that the government is borrowing a lower rates today, than when the bulk of our debt was borrowed. For scenario 1, I assume that our interest expenses drop by 31 bps a year for the next 2 years. Accordingly, our interest expenses remain around $400 billion a year, despite the fact that our borrowing level rise by $1.5 trillion a year.


If interest rates rise by a moderate amount, scenario 2, you can see that our borrowing costs will rise to $730 billion a year in 2013, and if I paint a somewhat darker picture as to what rates do, then we are looking at interest costs of $830 billion a year by 2013. In either of the rising rate scenarios, interest expense will rise to 50% of the total deficit. In short, there is no way we can withstand the assault of rising rates without calling into question our ability to ever repay back this debt.


While I do not believe the government will default on its debts, it is very likely that the government will dial back its obligations to senior citizens and the poor, while taxing the well to do to a greater degree. Furthermore, the US (the Fed) can easily invoke a rate cap, in order to keep our debt costs down, another theme I have harped on in past blogs. Of course, this might result in the Fed printing money as it buys back the treasury debt in monstrous proportions, which in turn will unleash a wave of inflation not seen during the history of this country. At the end of the day, the government will do what it needs to, in order to preserve itself. But I refuse to base any investment strategy on what the government will do.


Why am I using valuable space in my year ahead blog to talk about this (possibly) far off concept? While a Greek moment for the US is not likely in 2011, it is still something I need to keep prominent on our radar screens. It is out of respect for this scenario, that I recommend, and continue to recommend that homeowners take out as much money against their homes at today’s low (fixed) rates, even if they do not have viable uses for the money. You can always repay your debt, and having long term money while it is cheap, is a great option in case a calamity occurs.


As far as investing goes, this keeps me away from long term bonds, be it municipal bonds, treasury bonds or anything with a maturity above a couple of years. There is plenty of things institutional investors can do as far as buying longer duration bonds, as supposedly, their job is to keep an eye on things, and can dial down their durations along the way, as conditions warrant.


As for timing of bond investments go, I prefer to remain short duration over the next few months. I believe that 10 year treasury rates will hit 4% by the spring time, when conversation will turn to the Fed’s withdrawal from QE2 (scheduled for June), and the impact their absence will have on the rate markets. When concern about the Fed’s completion of QE2 in June reaches a widely publicized roar, and rates rise, probably in the March to April time frame, is when I think it will be a more prudent time to take a swing at buying duration in the bond market. I do not have a level in mind, just the timing. Of course, this will be for a 2-3 month play, but that is it.


The final caveat to my rates view is one which has a swoon in the equity and commodities markets, or a swoon in Europe, which in turn could create a flight to US treasuries. 


Beyond an expected rally in the spring, I will let my macro view dictate my actions, and I expect interest rates to be higher a year from now than today. I will have more on my 2011 outlook tomorrow.