You thought the bank bail-outs were expensive? You thought the so-called “stimulus” package added to the national debt? At least those economic policies were enacted in the public eye after extensive public debate and airing in the media. But one of the most important economic policies of the Obama administration, which potentially could add tens of billions of dollars in annual interest payments by the end of the decade, has gone largely unnoticed outside the bond trading community.
I refer to the the U.S. Treasury Department strategy for managing the public debt. Taking advantage of the extraordinarily low interest rates engineered by the Federal Reserve, Treasury financed much of the nation’s deficits in 2009 and 2010 by issuing short-term securities at near-zero rates, as opposed to selling longer-term debt at marginally higher rates. (Ten-year Treasuries closed last week at 2.75%.) That policy has the advantage of reducing interest payments in the short run but exposing the country to higher payments if and when interest rates rise.
The U.S. Treasury, like other national governments, tracks the average maturity of its debt. The shorter the average maturity — the more rapidly T-bills, notes and bonds expire and must be rolled over — the more quickly rising interest rates will translate into higher interest payments. The longer the maturity, the better insulated the country is from rising rates.
The chart below, taken from “Presentation to the Treasury Borrowing Advisory Committee,” shows the change in average maturity in U.S. debt over the past 30 years. In the early 1980s, interest rates were high but the anti-inflationary monetary policy created expectations that rates eventually would fall, so it made sense to keep the average maturity extremely short. The average maturity lengthened in the 1980s and 1990s, shrank again in the 2000s and then plunged during the 2007-2008 financial crisis.
After taking advantage of the super-low interest rates made possible by the global flight to quality, Treasury officials have begun lengthening the maturity again — and rightly so. Over the next decade, interest rates are likely to start heading north again as the economy rebounds and the aging populations of the advanced economies begin dis-saving to pay for their retirements. Some analysts suggest that yields on 10-year Treasuries could reach 10% by 2020. It makes sense for the Treasury to begin locking in 10- and 20-year yields (and 30-years, if they can find buyers for them) while the interest rate environment is so congenial.
So, at least the Obama administration is moving in the right direction. The question is whether Treasury is moving fast enough. The central banks of other advanced countries have longer maturities on their debt.
This chart shows the weighted adverage maturity (in months) of the debt of Japan and major European countries. Finland is taking the same gamble as the U.S. Everyone else has longer maturities.
Now, it’s possible that the U.S. is right and everyone else is foolish. If interest rates stay low, the wizards guiding policy at the Treasury will look like geniuses. The U.S. will save billions of dollars in interest payments on the debt. But if interest rates rise sharply, interest payments will shoot up rapidly. Then we’ll be kicking ourselves (or better yet, Treasury officials) for failing to lock in advantageous long-term rates at 3.6% (20 year bonds) while we had the chance.
Even under the sanguine 10-year forecast of the Obama administration, the U.S. will accumulate another $8 trillion in debt over the decade ahead. (As I argue in “Boomergeddon”, deficits and debt accumulation are likely to be much higher.) By the end of the decade, the national debt will exceed $20 trillion (Obama’s forecast) or $30 trillion (under a slower economic growth scenario). If over the same period interest rates triple or quadruple from current lows, the impact will be devastating. Interest payments on the debt, now less than $200 billion a year, could easily surpass $1.2 trillion a year.
Prudence dictates that Treasury hedge its bets by stretching out maturities this year as much as the market will bear.
Author's Disclosure: No positions