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A Quantitative Basis for Higher Interest Rates

2010 is off and rolling and it has been extremely volatile so far. A couple of trends worth mentioning that are persisting from 2009: “Ponzi Scheme” is by far the most pervasive incorrectly used phrase in existence and the other trend that is very persistent is that practically everyone believes that long term government bonds are set to fall at some point in the future. Granted, my first highlighted trend is just a rant at everyone in the world who believes anything unsustainable is a “ponzi scheme”; the second trend is actually worth some consideration.
President Obama quite literally served as a glorious catalyst for short sellers. His speech a few weeks ago on bank reform, which no doubt took the tone and rhetoric one would expect from Hugo Chavez, marked a wonderful selling point for one’s investment portfolio. The downward spiral has continued during the first week of February as pretty much every asset class spiraled downward with the exception of US Dollar and the Japanese Yen. The worry for the February…sovereign debt specifically, and budget deficits generally. 
The second persistent trend regarding interest rates in the United States is the focal point for this post. A significant portion of people suggest shorting long term debt of the United States citing a horrid fiscal situation–a fiscal situation that doesn’t appear likely to be resolved any time soon. However, thus far very few people actually try to measure the impacts that the deficit spending could potentially have on interest rates. They just make qualitative arguments, albeit based on sound economic logic.
In a recent research note by Barclays, this very topic is addressed. They attempt to frame the discussion of the impacts of deficit spending, as a percent of GDP, into a quantitative framework. 
They pose 3 arguments as to the impact of fiscal disarray on real GDP growth:
  1. The aggregate advanced economy G20 Government debt to GDP ratio is projected (by the IMF) to reach 118 percent of GDP by 2014. They note a study conducted by Carmen Reinhart and Kenneth Rogoff, Growth in a Time of Debt, which demonstrates that government debt to GDP ratios above 90 percent are associated with weaker real GDP growth. 
  2. The long-run fiscal outlook, due to aging, is extremely poor. They cite the IMF projections which point to advanced G20 government debt to GDP ratios rising by 50 percentage points of GDP over the next two decades due to aging.
  3. Containing the long-term government debt problem is going to be painful. This point is argued by citing the November 2009 IMF Fiscal Monitor which calculates that a return to pre-level crisis debt levels would require a 6.5 to 9.2 percent of GDP swing in advanced G20 economy structural budget balances over the next 10 years. Therefore the necessary fiscal tightening represents a significant medium-term drag on growth. 
In term of the impact increasing deficits as a percent of GDP will have on interest rates they conduct some quantitative analysis. 
“To quantify this point, we examined the experience of six advanced economies that have experienced large budgetary swings over the past 20-30 years. We compared the residual of a regression of 10 year yields on short-term interest rates to government deficit to GDP ratios. Essentially, we were seeking to discover whether or not there was a connection between deficit positions and the change in bond yields that was not caused by or related to change in policy rates. In all cases, we noted a reasonably significant relationship. The impact of a 1 percent change in deficit to GDP ratios on bond yields averaged 31 bps, within a range of 18bps to 37bps. This finding is similar to a recent IMF staff analysis, using somewhat different methodology, which suggests that a 1 percent shift in deficit to GDP ratios moves bond yields by about 20 bps. It is also similar to the results of an analysis contained in the latest Green Budget, authored by our Barclays Wealth colleague, Michael Dicks, which found that a 1 percent change in UK budget deficit to GDP ratios were associated with a 30 bps change in 10 year Gilt yields.”
The Barclays research paper goes on to highlight their alternative approach to examining this scenario.
“As an alternative approach, we examined how long term interest rates respond to the medium-term trend in debt to GDP ratios. In this analysis, we regressed U.S. 5 year, 5 year forward treasury yields on the rate of nominal GDP growth. The residual of this regression represents the portion of bond yields that cannot be explained by the trend in growth and inflation. We compared this residual to the 5 year compound annualized growth of the U.S. government debt to GDP ratios, finding an 80 percent average correlation and a relationship under which a 1 percent variation in the rate of growth of debt to GDP ratio moves the 5 year, 5 year forward interest rate by 40 bps.” 

According to their math, “the 5 year compound annualized growth rate for the U.S. government debt to GDP ratio stands at 6.4 percent. The historical analysis above therefore suggests that there is a 250bps upwards risk for 5 year, 5 year forward treasury yields. In similar vein, the U.S. budget position has deteriorated by 6.4 percent of GDP, if we exclude those measures that were specifically designed to support the financial system. Historically, a 1 percent shift in the U.S. deficit to GDP ratio moves long-term interest rates by 35 bps, so the deficit deterioration points to an upward risk of 224 bps for U.S. 10 year yields. If we include the financial support packages in our deficit calculation, the 9.6 percent of GDP deterioration in the budget deficit points to an upward risk of as much as 336bps fro long term U.S. yields.”
So wrapping this up…did this analysis refute the qualitative arguments posed by many that interest rates will likely rise in the future if the U.S. government does not get a really tight grip on their horrid fiscal management: No. But it does provide some sort of quantitative grounding for the argument.

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Disclosure: Long Eurodollars