Wednesday, June 03, 2009

Moving Weights From Left Pocket To Right Pocket May Decrease Weight

In a NY Times article posted online today titled "Rising Interest on Nations’ Debts May Sap World Growth" a classic anti-Bastiat mistake is made. Somehow the headline author seems to believe that if countries pay more interest, the world will grow slower, as if the extra interest payments are remitted by these nations into an incinerator.

Of course, common sense tells us that that interest will go to lenders and the lenders will choose how to spend it as opposed to the debtor nation. This of course has no discernible impact on world growth (and may be a net plus as, on the margin, it takes spending decisions out of the hands of governments and puts it into more efficient private hands) though it may certainly depress the remitting country's growth (depending on where their interest payments flow to).

The article addresses a point made by TILB just last week when we wrote:
To date, nearly all of those symptoms have manifested in one way or another, but we believe the most damning symptom could be the first: if the Fed does indeed lose control of long bond yields, watch out.

The yield curve on any term longer than a few years has backed up a huge amount in the last few weeks. In fact, with the Fed's ZIRP still firmly in place, the 2s/10s spread has widened out to record width, surpassing Greenspan's early 90s gift to banks (please always keep in mind that is a taxpayer subsidy). From the Fed's perspective, the danger of long bond yields rising is that it has the potential to unwind a great deal of their efforts to improve credit conditions for term borrowers, especially home buyers/refi'ers.

Further, the back-up in rates will make it increasingly expensive for the Treasury to term out We The People's debt. For example, the party-agnostic CBO uses an average 3.0% Ten Year Treasury Note Rate for 2009 and 3.2% for 2010 for budgeting purposes (see PDF page 52 here - note they also are far too optimistic on tax receipts due to their delusional GDP and unemployment assumptions, which we've already blown past). With the 10 Year having backed up 100bps in the past two weeks to 3.61%, we are already in the process of blowing the CBO's budget (the 30 Year has similarly moved to 4.49%). It's worth noting that the 2s/10s spread is wide today not because of absolutely high 10s but because of artificially low 2s (due to the Fed's ZIRP). [data as of 5/27/09 close]

So that is the precipice. If longer rates continue to move up on the back of the enormous supply ($2 trillion deficit likely this year, as we predicted back in January when most people thought $1 trillion was likely), then the government will have three choices:
1) continue to issue the already planned volume of longer bonds at higher rates and blow through budget projections resulting in yet more debt needing to be issued and enduring a further credibility hit;
2) monetize the debt by having the Fed step in as a buyer of unlimited volume at a pre-determined level (say 3.5% on the 10s) and risk rapid debasement of the dollar; or
3) move down the curve toward the short end where rates are cheaper but take on roll risk of epic proportions.

My guess is some combination of All of The Above with a lean toward #1 and/or #2.

This is either Custer's last stand and we are about to be ambushed or it's a beautifully executed rear guard gambit by our Fed and Treasury, maintaining a strong-enough dollar while financing the deficit and arresting a credit crisis all at once.

My suspicion is the former.

If I am correct, there is a serious potential for all hell to break loose in the next year as the dollar gets obliterated from a purchasing power standpoint putting the Fed in one hell of a bind. They either deal with the dollar's weakness by tightening - which may precipitate a financial panic and prove Bernanke a liar for his apology to Milton Friedman - or they actively debase, calling into question the dollar's reserve currency status, punishing savers to help borrowers, and setting loose the inflation to end all inflations...which of course will ultimately force them to tighten.

In essence, under either scenario the Fed will have to tighten against their preferred policy. It is simply a question of when they do it and what type of pain we are interested in taking between now and then. Admittedly, this is not an attractive set of choices. I do not begrudge Bernanke his roll in history.
This of course all seems obvious when you think about it, but what's shocking is that so little attention is directed toward it.

In any case, TILB Kenneth Rogoff is quoted in the aforementioned NY Times article (see below, heavily edited):
As governments worldwide try to spend their way out of recession, many countries are finding themselves in the same situation as embattled consumers: paying higher interest rates on their rapidly expanding debt.

Increased rates could translate into hundreds of billions of dollars more in government spending for countries like the United States, Britain and Germany.

Even a single percentage point increase could cost the Treasury an additional $50 billion annually over a few years — and, eventually, an additional $170 billion annually.

This could put unprecedented pressure on other government spending, including social programs and military spending, while also sapping economic growth by forcing up rates on debt held by companies, homeowners and consumers.
But in the last three weeks, the pace of the increase in the 10-year Treasury note’s yield has quickened, spurred by a Congressional Budget Office estimate that net government debt will rise to 65 percent of the gross domestic product at the end of fiscal 2010, from 41 percent at the end of fiscal 2008.

In 2009 and 2010, Washington will sell more than $5 trillion in new debt, according to Citigroup. A decade from now, according to the Congressional Budget office, Washington’s outstanding debt could equal 82 percent of G.D.P., or just over $17 trillion.
Under President Obama’s 2010 budget, total interest payments by the federal government could rise to $806 billion in 2019, from $170 billion this year, according to the Congressional Budget Office. Much of that projected increase is a result of higher government borrowing, but the forecast also assumes that the average 10-year note yield will increase to 4.7 percent.
“It’s a gigantic issue,” said Kenneth Rogoff, a Harvard professor and the co-author of a forthcoming book, “This Time is Different: Eight Centuries of Financial Folly.” “It leaves us very vulnerable to a global rise in interest rates that might be substantially beyond our control.”

Mr. Rogoff estimates that if the budget office’s debt estimate proves correct, every one percentage point increase in rates could eventually cost Washington an added $170 billion a year.
A year ago, under old budget and policy assumptions and before the financial crisis escalated, the Congressional Budget Office projected that outstanding federal debt would hit $5.3 trillion in 10 years.

“It’s an exaggeration of course, but it’s a little like what happened to the subprime borrowers,” Mr. Rogoff said. “People are just assuming the funding will always be there.”
Britain’s debt sales might seem less alarming than the multitrillion-dollar offerings from the euro zone and the United States. But Mark D. Schofield, global head of interest rate strategy at Citigroup in London, said, “It’s a huge increase in percentage terms, and it dwarfs anything else.”

Standard & Poor’s caught some traders and investors off-guard last month when it warned that Britain’s sovereign debt was in danger of losing its AAA rating, lowering the outlook to negative from stable. It was the first time since Standard & Poor’s initiated coverage of British debt in 1978 that the country received a negative outlook.

Britain’s government debt now equals 55 percent of G.D.P., but Standard and Poor’s estimates it could approach 100 percent by 2013.