Indebted to the Future?

Will future interest rate payments chain down America’s future budgets? Source: Fox Photos/Getty Images.

Hark! This way another budget battle cometh. The debt ceiling. Funding the Affordable Care Act. All the wrangling and talk ties into near omni-present US debt fears. For example, tell someone the US government’s debt interest payments are a fraction of what they were in the go-go 1990s, and a typical response is something like, “Yes, but we’ll be doomed when rates rise.” A recent paper argued exactly this point, projecting rising government bond rates far into the future and suggesting they’ll overtake entitlements as our nation’s single biggest expense—and potentially bring a crisis. In our view, however, investors should largely chalk this up as long-term forecasting noise—and noise with faulty methodology at that.

According to the paper, as interest rates start rising from near-generational lows, debt-service costs will grow significantly—from about 6% of the 2013 budget to almost triple that amount in 2030 and 25% by 2050. To arrive at these figures, interest rate changes are applied across the board to all Treasurys at the same time, in a standard linear fashion. And this is where the methodology has a teensy hiccup.

Rising interest rates only affect the government’s payments on newly issued debt—payments on existing bonds don’t change. Even the long-term bond yield increase we’ve seen as the market discounted taper talk has had no real effect on government finances yet. You see, the government is—even now—refinancing existing debt at lower rates than they were paying. 5-year Treasury notes issued in September 2008 are being refinanced at about a one percentage point lower rate; 7-year note rates halved from 2006 to today, and 10-year Treasurys are noticeably lower from 2003 to today. (Exhibit 1)

Exhibit 1: 5-, 7- and 10-Year US Treasury Constant Maturity Rates (Today and 5, 7 and 10 Years Ago)

Source: Federal Reserve Bank of St. Louis. 5-year rates are as of 09/18/2008, 7-year as of 09/18/2006 and 10-year as of 09/18/2003. Current rates are as of 09/16/2013.

While it’s always possible interest rates can jump suddenly and quickly, minimal default risk and low inflation expectations make that scenario unlikely. Looking forward, interest rates could continue rising, but it would take a significant, long-lasting increase to materially impact affordability. Hence, projecting a smooth increase in rates universally across the government’s debt stock is actually quite a large error.

As is making such long-term projections—always folly. To make an accurate long-term projection of 20+ years, one must perfectly foresee—and account for—every last piece of legislation, innovation, unintended effect (both positive and negative), disaster and the generally unexpected. Extrapolating the past into the far future won’t cut it. For example, consider the Congressional Budget Office’s Long-Term Budget Outlook from 2000 based many of its conclusions on the assumption we’d have a budget surplus for the next decade. Oops! But if that had played out, we doubt any of the prevalent talk of today would exist. That’s not to single out the CBO, but rather, the usage of long-term projections in general—too many variables exist for there to be consistent accuracy.

Speaking of the budget deficit, it’s currently on track to hit the lowest level since 2008 (See Exhibit 2). While spending cuts and tax increases influence this, it’s also a sign of a growing economy—higher tax revenue is a side effect of rising US earnings, incomes, investment and sales. The government collected $185 billion in taxes this past August, up 4% y/y. That adds to an already much better than initially forecasted year for the government. At the start of fiscal 2013, the White House Office of Management and Budget foresaw a deficit of over $900 billion. But with 11 months in the books and a typical surplus month (September) remaining, the CBO now projects a deficit of $642 billion in fiscal 2013. Now, that’s still a relatively big number, but it has been more than cut in half since 2009. Its gradual reduction over the past few years seems quite overlooked by debt-fearing investors and serves as another reminder of how strong (and underappreciated) the US economy really is.

Exhibit 2: Budget Deficit Since 2009

Source: Office of Management and Budget, as of September 17, 2013.
*Fiscal 2013 is the Congressional Budget Office’s estimate as of the end of August 2013.