GOVERNMENT BORROWING IS GETTING MORE EXPENSIVE: INTEREST RATES RISING

Over the past year and a half, the economy has been in a near-depression state.  As a result, the Federal Reserve printed easy money and lower interest rates to encourage investment.  To make interest rates easier, investors flocked to buying treasury debt and other high-rated debts to the point that some of them provided zero or negative returns.  This held down rates and helped people take out mortgages at historical rates.

The low rates also helped the government borrow close to $4 trillion at near-zero rates and actually provided the government a $60 billion stimulus as rates on the previous $8 trillion fell and lowered the interest expenses associated with that debt.  Currently, the government is due to spend about $450 billion per year in interest expenses for 2010.

The government debt is about $12 trillion, therefore the government’s interest rate is about 3.75%.  When determining what the market interest rate is, investors should look at the 10 year bond rates.  The 10 year notes are located in the middle of a yield curve that includes a variety of treasury durations from one month t-notes to 30 year treasury bonds.  The yield curve yesterday looked like this.

Low interest rates have been held low due to high investor demand.  Even the Federal Reserve stepped in and bought $300 billion in long-term treasuries last year.  However, this level of demand is temporary for several reasons.

1)      Equity markets are improving.  With the stock market giving returns as high as 5% over a 30 day period, people are going to sell their treasuries and go to stocks.  Why take a 1 to 3 percent annual return on treasuries when you can do better owning stocks for one month.

2)      The amount that investors used to borrow came from years of earnings.  This means that investors won’t earn enough money in 2010 and 2011 to buy the massive amounts of debt that the government plans to issue. 

3)      Foreign governments have become less willing to buy U.S. debt.  China, Japan, and the EU all have their own fiscal problems.  We cannot count on their contribution to our debt that they have had in previous years.

So what does reduced demand mean?

When there is trouble buying treasuries, interest rates rise in order to attract investors.  With the stock market doing well, the treasury market has to make their notes less expensive and offer a competitive return to stocks in order to keep buyers.  With such a massive amount of debt being issued, treasury rates may have to move quicker in order to induce buyers.

How does this affect you?

The treasury market is the number one influencer of interest rates.  It affects the mortgage market as new mortgages are underwritten based on treasury.  Variable interest rate mortgages adjust based on the interest rate fluctuations.  Any consumer loan (car, credit card, payday lending, etc) is influenced by interest rates.  On top of that, businesses rely on credit to operate.  As interest rates rise, these businesses have more trouble accessing credit and their interest rate expenses would increase.  If your employer has these problems, it may jeopardize your employment.

Now, the purpose of the article isn’t to alarm you, it’s to demonstrate that when the government borrows money, it has more to do with you than your tax obligations.  As the chart below shows, government borrowing has accelerated as a result of this crisis, and is expected to remain elevated through 2014.

Additionally, as we can see, the 10 year treasuries rates have increased and expect to continue to increase over the next couple of years.

Finally, there is the big burden that each reader has, the taxpayer burden.  While the expenses for interest on the debt seem high at $400 or $500 billion, it’s about to get worse, according to the administration’s budget projections.

Let’s hope that interest rates don’t “spike” as a result of poor treasury demand.  The above numbers could become much worse and our sovereign debt issue could become a larger problem.