I am up very early today – 3 a.m. – that’s what happens if you go to bed at 8 p.m. Honestly I do my most clear thinking very, very early in the day. This morning my thoughts are on interest rates. These thoughts are difficult to consider without politics being part of the discussion–but political discussion is not allowed here so I will work around the obvious (Congress must cut spending or increase revenue).
We all know that the U.S. Treasury will be selling huge amounts of debt in the next year (and, of course, likely for years). And the fact is that in the next 10 years we will have massive amounts (read trillions and trillions) of NEAR ZERO (actually the average of outstanding debt was 1.61% in 2021) coupons in bills, notes and bonds maturing, which will be replaced with bills, notes and bonds all with coupons at 4-5%. Just like all the banks that have been reporting earnings in the last couple weeks the cost of funding for the treasury has increased many times over. Unlike the banks which balance the increased cost of funds with higher interest rates for borrowers the Treasury is not able to charge borrowers higher rates so they essentially have to ‘eat’ the increased cost of funds. ‘Eating’ these costs simply adds to the Federal deficit in the form of higher interest costs and the vicious circle goes on and on for years and years.
As of September, 2023 the cost of Federal debt service is running at $879 billion which is 14% of all federal spending. TODAY the average cost of debt to the U.S. treasury right now is around 3% and CLIMBING–so debt service is climbing to $1.7 trillion/annually (28% of total spending) and headed even higher. NOTE–all numbers from the U.S. Treasury website here.
So on the surface it looks like we are totally screwed. Is there even enough money in the world to fund our debt? Yes, for now, but at what point do investors lose confidence in the ‘full faith and credit’ of the U.S. to pay their debt? This is where the ‘rubber meets the road’ and for which there is no answer.
While we know that the Fed can lower the Fed Funds rate when the economy cools – but that doesn’t necessarily mean that 10, 20 and 30 year coupons are going to fall- investors may well demand higher payments for longer. Maybe they demand 6, 7 or 8%?
Now it is funny that this point of view is totally in contrast to the view of Bill Ackman, Bill Gross and other big names. These folks have moved from shorting treasuries to buying treasuries all based on a softening economy, but I am not sure I have read their perspective on debt and the ever higher debt service costs. Certainly on a historical basis interest rates would react primarily to economic conditions–but at what point do they trade based on the credit worthiness of the borrower? Maybe these ‘smart’ folks are looking at a 6 month horizon while I am trying to focus on a 5 year period.
I suspect that next year – very late in 2024 we will see the Fed discontinue quantitative tightening and then in 2025 start to cut the Fed Funds rate and then in very late 2025 begin quantitative easing–as the buyer of last resort so to speak. With the ‘run off’ of the Fed balance sheet (providing space for new purchases) the Fed can ‘bail out’ the treasury for a couple years until their balance sheet goes over $10 trillion–but at that point the deficit spending is so out of control that there would seemingly be no ‘out’.
So maybe we see long term rates fall with a soft economy for a bit–a year or two, but then we see interest rates skyrocket — I mean really skyrocket–20% when the global investors determine that the U.S. is going the way of the ancient Roman empire.
So today life goes on – just like yesterday and last week and last month. What the next 5-10 years holds isn’t known by anyone–and certainly not me.