Common Cents on October 5, 2018

October 4, 2018, by John Norris

This week, a colleague asked me whether I thought the projected amount of additional Federal debt over the next decade would have a detrimental impact on interest rates. Another way of putting their question was/is: “we are already $20 trillion in the hole in Washington, and will be $30 trillion in the red in 10 years. Interest rates should go UP, right?” This makes perfect intuitive sense.

After all, it would seem to be basic Econ 101. When the supply of something goes up more rapidly than the demand, the price goes down. It doesn’t matter if it is tiddlywinks or government debt. Since there is an inverse relationship between bond prices and interest rates, a continued increase in US borrowing should lead to higher interest rates as the supply curve shifts out to the right. Or so the thought process goes.

So, they were a little surprised when I said: “not necessarily.” You might be as well.

The primary reason for that answer is pretty simple, that is IF you have been working around the bond market your entire career: longer-term interest rates are a reflection of inflationary expectations. If the Treasury borrows another $10 trillion over the next decade AND the markets anticipate inflation will hover in the 2-3% range, like it has for the seemingly forever, there is no reason why the yield to maturity of the 10-Year and 30-Year US Treasuries would skyrocket.

Think about it: if inflation is running 3%, what is YOUR entry point into the bond market? At what point do you, as an investor, think the return is decent enough? I would be willing to bet dollars to doughnuts that number is in the 5-6% range. Shoot, it might even be less than that, as inflationary expectations are currently running around 2.1% and the yield on the 30-Year is around 3.35%, or thereabouts.

Is that all investors need? Is that all the compensation they need to invest out on the yield curve? 1.25% or so? If that is the case, perhaps 4.25-4.50% might be an attractive level for a lot of investors when inflation is 3%. Maybe that is the new normal, who knows? Historically, it has been closer to, say, 2.50-3.00% to invest that far out on the yield curve.

So, I guess I could have or should have followed up my response to them with a question of my own: “what is YOUR definition of higher interest rates?” A ha…therein lies the rub. Are we talking about Carter-era and Paul Volcker interest rate levels? Or are we talking about just higher than they currently are, by any amount, large or small?

As I type here today, the markets anticipate inflation will be roughly 2.1-2.2% over the next 5, 10, and 30 years. This is nothing more than the difference between the yield to maturity of so-called ‘on the run’ US Treasury securities and the comparable ‘Treasury Inflation-Protected Security (TIPS).’ This is what the current money is saying, and lots of it. So much capital, it is almost impossible to imagine the markets NOT taking into consideration the projected additional accumulation of US Treasury debt over the next decade.

Essentially, while it wouldn’t be impossible, it would be very curious to see US interest rates climb to, say, double-digit levels WITHOUT an adjustment, and a pretty significant one, to what the market expects for inflation moving forward. Indeed.

Therefore, whether they realized it or not, my colleague’s question might have been or should have been: “will an additional $10 trillion, if not more, in US Treasury borrowing lead to greater inflation over the next decade?” Hmm. That is a much harder question to answer.

While I am supposed to say things like “past performance is not indicative of future results,” the last $10 trillion hasn’t been terribly inflationary, at least as defined by the official inflation gauges. Since you can find inflation wherever you want, you have to take some of the government data with a grain of salt…if not a pound. After all, it is most definitely in Washington’s best interests, at least currently, to report muted inflation numbers. This keeps COLAs in check, as well as, you guessed it, the bond market. The latter puts some measure of predictability on future debt service obligations.

As an aside, at some point, state and local governments will clamor for higher interest rates IF for no other reason than to discount the projected benefit obligations on their unfunded defined benefit plans by a greater amount. However, that is a discussion for another time.

Still, the official numbers are what they are. Further, the government has basically rigged the calculation of some of these inflation indices such it would be well-nigh impossible to see Carter-era misery moving forward. Upon immediate reflection, perhaps impossible is a strong word. Let’s use improbable or highly unlikely instead.

Clearly, imbedded in all of this is my personal bias, if you want to call it that. Will increased US borrowing lead to higher interest rates? Sure, if it causes inflation to creep up, but I don’t consider, say, a sustained 3% Consumer Price Index number a problem. Too much past 4% is where I start scratching my head, but that is about double where the money currently thinks it will be in the future.

So, in conclusion…no. Increased US borrowing won’t lead to higher interest rates in and of themselves. If inflation accelerates because of this increase, they certainly will. However, what is an absolute number on which we can all agree? Where we can point our fingers and say: “a ha! There you have it! All this borrowing has led to higher rates, just like we thought it would!” Is that number 5%? Or 6%? Perhaps you won’t lose sleep until 7% on the 30-Year, even if everyone else might!

Now, with all of this said, or written as the case may be, IF I were making a book, I would start, today, the over/under line on the yield to maturity of the 30-Year US Treasury Bond on 10/4/2028 at…drum roll please…5.18%. That is 3.0% higher than the current spread between the ‘on the run’ and TIPS debt, and is just math.

But…but…but, Norris, you started off by answering the question with “not necessarily.” Now, you are throwing out a 5.18% number. So, you DO think they will lead to higher interest rates! Gotcha!

Well, maybe, but there are a lot of other things that will play into that yield other than the absolute levels of US Treasury debt. Further, and this is THE important point, I wasn’t running a book at the beginning of this short newsletter.

Hey, don’t hate the player.

 

 

Have a great weekend.

John