Wall Street Worries Over Swelling US Debt Put Fed in Tight Spot
Financial institutions are taking precautionary steps in preparation for a possible breach of the debt ceiling, which could trigger massive rises in interest rates and market instability. They have planned for all eventualities by creating payment strategies for Treasury securities they hold and making sure that enough staffing and technology exist to handle sudden surges in market volatility.
Interest Rates
As the Federal Reserve prepares to begin cutting its balance sheet, some investors have voiced concern that its action may cause too great an economic slowdown. But there's more at play: interest rates.
Longer-term mortgage rates could be affected significantly by Federal Reserve rate hikes.
The reason is, that while Fed monetary policy affects borrowing costs for businesses and consumers, its greater concern lies with what those higher rates mean for government debt. Simply put, rising debt will push up interest rates further, necessitating yet more increases from the Fed itself.
This is due to the Treasury not locking into long-term rates when borrowing, preferring cash-flow bonds with maturity dates of one or two years instead. Thus, any one percentage point increase in interest rates increases Washington's debt service bill by $30 trillion over 30 years.
If current trends continue, our national debt will reach close to 300% of GDP within three decades, driving annual interest spending up to 8.6% of GDP or 6.6% after inflation; more than half of federal tax revenues would then go toward servicing interest payments alone and rendering other essential government programs such as Social Security and Medicare unsustainable without massive tax hikes, spending reductions or the threat of massive financial instability.
Given the unreliability of economic forecasters and the nature of economic variables like interest rates to change over time, projections should cause anyone to pause. Of particular note is the Furman/Summers standard, which hinges on hoping interest rates remain below CBO projections permanently.
Bet on stopping at a stop sign while travelling at full speed? That would be like betting your car can stop instantly at an intersection while travelling at full speed; to increase safety, it would be wiser to gradually reduce speed as you near it, so most experts expect the Federal Reserve will "taper" its asset sales rather than abruptly cutting them back all at once.
US Debt
Since 2009, our national debt has reached unprecedented heights, driven largely by Social Security and Medicare shortfalls that threaten to drive federal budget interest costs through the roof. Under these escalating costs, the national debt is projected to surpass 200% of GDP within three decades - even with modest interest rates. At that level, Washington would lose all tax revenues, and the economy would suffer as it shrinks. Soaring interest costs are difficult to reduce as the policies which pushed them upward are likely politically irreversible unless there is some radical deviation from existing policy (for instance, the Federal Reserve irresponsibly monetising much of the debt).
To finance its surge in deficit spending, the US needs more lenders than ever before. Traditional investors such as China and Japan -who traditionally funded deficit spending- are unlikely to come forward, given that their national savings have already fallen below 100% of gross domestic product. Instead, domestic lenders such as retirement funds, mutual funds, federal agencies, state/local governments, etc, may come forward. Still, for them to fund $100 trillion over 30 years, the Treasury will need to offer significantly higher interest rates than it currently offers them.
Investors are worried about rising national debt because of the expansion in the Federal Reserve balance sheet since the financial crisis. The Federal Reserve holds assets from government-sponsored enterprises like Fannie Mae and Freddie Mac that comprise most of its holdings, which make up its assets. But the Fed also provides access to various credit facilities, such as its Term Auction Facility, which supports liquidity in the commercial paper market and Municipal Liquidity Facilities, which support municipalities and states. These and other lending facilities are intended to keep credit markets operating, encourage economic expansion, and offer emergency support in case of a severe recession or another crisis. As a result, the Federal Reserve's balance sheet has quadrupled over the last decade.
US Economy
At present, the US economy remains healthy, with unemployment nearing 50-year lows, consumer spending remaining steady, and inflation generally on the wane. Yet recent events, including several regional US banks failing and one large Swiss one shutting their doors, have reminded people how vulnerable our financial system really is; consequently, the Federal Reserve has taken steps to rebalance its support by decreasing the stimulus level given to financial systems.
Since the Federal Reserve's shift, investors are moving money from shorter-dated securities into longer-dated ones, narrowing the spread between 2-year Treasury notes and 10-year Treasuries and pushing yield curve inversion towards recession-like territory.
Concerns stem from projected budget deficits resulting from rising debt levels that will become unsustainable over time. According to projections by the Congressional Budget Office (CBO), unchecked federal debt would reach 250% of GDP within three decades, swallowing up nearly all government tax revenues and skyrocketing interest costs to unsustainable levels.
These debt-to-GDP projections are not merely theoretical forecasts; rather, they reflect real spending commitments made under the law. Social Security and Medicare costs drive these projections; future changes to healthcare cost trends or poverty rates may slightly alter them but cannot stop the rapid accumulation of structural deficits.
Another issue is the unsustainable combination of surging debt and rising interest rates; even if US officials can temporarily keep rates low, the debt-to-GDP ratio will still keep growing as interest costs escalate; should this threshold cross, this could spark a debt crisis.
Furthermore, many do not feel very positive about their finances. According to a Gallup survey released earlier this month, 50% of American families report worse financial situations now compared with last year - this could cause consumer spending to decrease sharply and make it difficult for households to absorb rising interest-rate payments on mortgages, credit cards, or auto loans.
Fed
After the global financial crisis of 2008-09, the Federal Reserve rushed into emergency mode, cutting rates near zero and injecting trillions into markets and the economy through quantitative easing programs. Their balance sheets ballooned dramatically as they purchased debt from banks and lenders as well as mortgage-backed securities whose buyers received cash flows from multiple home loans.
The problem is that debt has accrued at an unsustainable pace. Even moderate long-term interest rate changes can trigger debt surges that increase budgetary interest costs significantly, as CBO's recent baseline forecasts demonstrate.
One major issue facing the Federal Reserve is its inability to create a backup plan in case debt doves become convinced that relatively low-interest rates on their debt will remain steady, but that could prove dangerous as increasing debt levels coupled with rising rates could spark off a fiscal crisis.
Even if federal interest expenses remain at reasonable levels, rising income taxes and entitlement spending are expected to drive deficits to unsustainable levels over the coming 30 years. Social Security and Medicare systems alone will consume over 6% of GDP over this time, swallowing up every tax dollar Congress raises or cuts from tax revenues.
That means any increase in budget interest costs would force Congress to cut spending or raise taxes to cover additional costs - an immense political challenge, given that lawmakers and voters might be unwilling to give up retirement income or benefits just to save trillions on deficit reduction.
As the Federal Reserve works to unwind its quantitative easing policies, it will need to reduce its balance sheet by selling some treasury bonds and mortgage-backed securities from its books - something which may cause prices for these assets to surge as demand outweighs supply, also increasing mortgage rates due to an expected reduction in supply of these instruments.
