Government Debt – According to the Department of the Treasury, the amount of Federal Debt Held by the Public has nearly tripled over the last 10 years from $4.81 trillion in May of 2006 to $13.83 trillion today. The Total Public Debt Outstanding, which includes “intragovernmental holdings” (mostly interest payments to the Social Security Trust Fund), now amounts to $19.2 trillion. By this measure, total debts have more than tripled since the year 2000, when Total Public Debt Outstanding was $5.78 trillion.
Traditionally, such an increase in government debt over such a short period of time would result in higher interest rates demanded from bond buyers. Traders and investors would perceive the government as a greater lending risk and foresee higher future inflation as such governments were forced to print money to make necessary payments on the debts. More money printed generally results in a depreciating currency and higher interest rates. However, as I noted in my last article, Japan has reinvented the model of how governments could finance themselves and specifically, how they could “successfully” (for a time) manage very high debt levels while manipulating interest rates lower than the market would normally allow.
Regardless, while high-debt countries like the U.S., Japan and others may still be able to issue large amounts of debt every year to willing buyers, these governments still need to pay interest on those debts. Low interest rates help reduce that interest but at least at this point, interest hasn’t been eliminated, at least not in the U.S.
The graph below shows Federal interest payments along with Federal debt levels. These figures are according to the U.S. Treasury. The debt outstanding is the larger of two common measures of government debt: Total Public Debt Outstanding. This measure includes the large debt now owed to the Social Security Trust Fund. Over the past few decades Social Security has paid less out in benefits than it has taken in from taxes but the government has spent all those surpluses. In its place they’ve issued debt to cover it and as a result have been paying interest into the Social Security Trust fund every year. This Social Security debt has now grown to nearly $6 trillion and is one more debt that the government is theoretically liable for. Although it is essentially one branch of government paying another, the government counts this as interest paid and includes it in its Total Public Debt Outstanding as well as yearly interest payments on debt, which I’m showing here.
We see on the chart the dark grey line indicating the total accumulated debt over 28 years. Over that span, U.S. Federal Debt has grown more than seven times, from about $2.6 trillion in 1988 to over $19 trillion today. The dark red line shows yearly interest payments on that accumulated debt. We see that while interest payments have generally grown, they have grown much less than overall debt levels. In particular, we notice that over the past decade, interest payments of debt have not really grown at all. However, that’s not a function of financial discipline but more to the effect of interest-rate management.
The government has been very active in the interest rate suppression business since 2008, when it took short-term interest rates to nearly zero and began talking long-term interest rates down to a level where the 10-year Treasury bond rate has averaged about 2.5% over the last decade. As a result, the government pays a lot lower interest rate on its debt. According to the Treasury Department, the average interest rate on outstanding U.S. government interest-bearing debt is currently about 2.32%. That’s roughly half the level of 2008, and barely a third of the level at the turn of the century. So the good news for the government is that the interest rates they’re paying on their debt have been pushed down over the past decade. The bad news is that the amount of debt they pay interest on has exploded. Combining high debt but low interest rates has kept interest payments contained over recent years.
But what if the average interest rate that the government was paying on its debt crept up to say, 5%? (In the year 2000, the government was still paying about 6% a year on its debts, and much higher rates in prior decades.) A 5% interest rate on nearly $20 trillion debt would result in interest costs of about $1 trillion a year, instead of about $440 billion in 2016. With today’s debt levels, each 1% rise in the average interest rate it pays on its debt would result in close to $200 billion in extra year interest costs. Allowing interest rates to rise by 2%, 3% or 4% would blow a gigantic hole through the government’s yearly budget deficits. Those additional budget deficits would then lead to their mountain of debt growing even more quickly, resulting in additional interest payments increases, more debt increases and so on. The government simply can’t allow that to happen.
Perhaps a decade or two ago the government would have been willing to let interest rates rise in response to rising economic growth, higher inflation or expanding financial bubbles, but today, the amount of extra interest it would pay on its debt each year would make it economically and politically undoable. This fact alone makes it nearly impossible that the government/Federal Reserve will let interest rates rise to a normalized level.
Corporate Debt – Ever since interest rates have been pushed down by Central banks, corporations around the world have been taking on more debt, leveraging themselves up in response to abundant and cheap credit. The graph below shows the increases in debt within the U.S. over the last decade. Over the last few years we see yearly corporate debt growth in the 6%-8% range, far in excessive of revenue growth in the U.S.
A recent article by Bloomberg described how debt-to-earnings ratios of global companies has now surpassed three times, the most in more than a decade (see chart below). According to Bloomberg analysis, one third of companies globally are not earning high enough returns to cover their cost of funding (debt). In 2015, rating agency S&P downgraded the debt of 863 companies, the most since 2009. A third of energy and commodity companies are on “credit watch” with expectations of debt downgrades.
When companies are highly leveraged and are already struggling to generate enough earnings to pay interest on their debt, we can only imagine what would happen if corporate interest rates were to revert to more normal, higher levels. Clearly, a large portion of today’s economic activity would not take place if interest rates were higher. Ultra-low interest rates and extremely easy credit conditions have led corporations to borrow to finance speculative ventures that wouldn’t have been considered with normal borrowing costs.
Those speculative ventures include issuing debt at very low interest rates and using the proceeds to finance other companies and/or buy back the stock of one’s own company. According to Boston Consulting Group, worldwide spending on mergers and acquisitions was 4.7% of global Gross Domestic Product in 2015, roughly double the levels from 2008-2013, and the highest level since 2007. That included more than $2 trillion of deals from U.S. companies, the most ever.
But with record borrowing, comes record interest costs. J.P. Morgan reported last year that companies spent $119 billion in interest costs over the prior year. And that is with nearly record-low interest rates (see below). If corporate interest rates reverted to higher levels, even more pain would spread among companies.
Over the last several years, weak “organic” earnings and low interest rates impossible to pass up, have led corporations to splurge on debt. That includes a record $1.49 trillion in bond issuance in 2015 in the U.S., according to Securities Industry and Financial Markets Association.
Having now splurged for several years, higher interest rates would slam the corporate world, stock and bond markets and the worldwide economy. Such a rise will be strongly resisted, by companies and the Federal Reserve.
Financial Markets – The Federal Reserve knows that even modestly higher interest rates would rock the financial markets. Those markets have become very accustomed to low interest rates and extremely slow and incremental increases in those rates. It should be remembered that it was the past Fed Chairman Ben Bernanke who first warned that the Federal Reserve might raise interest rates back in 2012, three years before the rate was increased by a meager .25%. Even such a small increase with repeated warnings over a long time roiled financial markets and sent the world economy spinning.
As I have noted before, using objective standards such as the Schiller p/e ratio, market value to GDP, and other measures, the U.S. stock market is currently very expensive. (For more on the valuation of the financial markets, current and past, I suggest you look at some of the many wonderful articles by John Hussman where he provides terrific research and analysis into the valuation of the financial markets. http://hussmanfunds.com/weeklyMarketComment.html)
The typical cause of overvaluation in the financial markets is easy credit conditions. It provides fuel for speculation, increases malinvestment, and is often provided near the top of economic cycles where profitable opportunities of economic growth have evaporated. Easy credit then encourages ventures into more speculative avenues, which provides extra growth for a while, but also the eventual fall as those speculative ventures are wiped out in the ensuing bust. One way to observe financial speculation is to observe borrowed money (margin) invested into the stock market. The chart below from Doug Short and Advisorperspectives.com, shows the clear relationship between margin debt and the stock market going back more than 20 years. We see margin debt increases along with the stock market, often surging to market peaks as in 2000 and 2007 before crashing along with market. In this latest economic cycle it appears margin debt has peaked, though it remains to be seen if margin debt and the market will continue their decline in tandem as in the last two economic cycles
Speculators are encouraged by market action. When the market is rising they buy (and borrow) more. When the market is falling they do the opposite. But of course, buying more stocks on margin also fuels the market. And when stocks are liquidated to pay down margin, stocks are pressured downwards. The two reinforce each other.
Speculators are also encouraged by low interest rates. Generally, the lower the borrowing costs (interest rates) for the potential speculator, the more likely he or she is to borrow and put that money into the stock market. The inverse is also true. If interest rates are allowed to rise, not only is margin debt likely to fall, but more casual speculators (i.e., those not borrowing to invest) will decide not to invest some of their cash in the stock market. Every interest rate increase takes a certain amount of speculators out of the market. My belief is that raising rates 3%, 4% or 5% would remove much of the speculation out of today’s financial markets. And if it is indeed speculation that is helping to levitate the financial markets, removing most of those speculators from the marketplace would lead to a substantial repricing of the financial markets, perhaps 20%, 30% or even 50% lower.
There are other reasons that interest rates won’t be allowed to rise but I think these are three pretty important ones. At the end of the day, even the most bullish individual has to admit that it’s not a healthy economy or market if the only way to get “good” results is to take extraordinary efforts to constantly manipulate interest rates downwards.
If the economy was truly healthy there would be no need to keep interest rates at such low levels. In a (true) market, interest rates naturally rise as the economy overheats or inflation or speculation increases. This has the result of naturally reducing the amount of economic speculation and excess and bringing the market back to equilibrium. The opposite is true when the economy or prices are falling and interest rates naturally fall, sopping up excess supply and helping to balance the economy.
Basic economics and common sense tells us that except for extreme circumstances, higher interest rates are what are needed to attract the necessary savings to allow for capital investment, which further leads to productivity increases and sustainable economic growth. Extremely low rates of interest discourage saving, encourage consumption, lead to capital depletion, malinvestment and speculative booms and busts. However, at this point, after 8 years of interest rate manipulation, the government and the Federal Reserve has painted itself into a corner. There is no path to higher interest rates that won’t cause extreme pain. And they just won’t allow that to happen.