Savers Beware

Bond market yields are lower now than when the government was running a surplus a decade ago. Something is wrong with this picture. If you didn't know otherwise, the low yields might lead you to believe that our national debt is low and sustainable. Further, just looking at the current yields,  you might think that our future budgetary concerns have been resolved due to significant entitlement reform. 

The Federal Reserve’s Involvement

If real reform has not happened, then why hasn’t the bond market called the government’s bluff and reacted negatively to the prospect of future insolvency? Part of the answer is in the question – future. Currently, everything is working. There is no crisis, and so the market is behaving as such. The government has a habit of only dealing with problems when they become crises. On the other hand, maybe the reason the bond market has not signaled caution is because a rather large participant (and that’s putting it mildly), namely the Federal Reserve, has been buying pretty much all of the debt. A government entity is buying government debt thereby expanding its already massive balance sheet. I don’t care how you spin it, but something is not right with that picture.

The Federal Reserve’s second round of quantitative easing ended in June. Ironically, the ramifications of the program ending, along with a slowdown in economic growth, continued Eurozone sovereign debt worries, and the U.S. debt ceiling fight, have caused people to flock to the safety of Treasuries sending yields back down to historic lows.

The Fed plans to continue maintaining its balance sheet by reinvesting principal and interest in an attempt to provide support for the anemic recovery. At this point, all further actions by the Fed produce lower marginal gains for the risks taken. The Fed is in no hurry to reduce its massive balance sheet, and it looks like it will not raise rates until well into 2012 and possibly 2013. I don’t believe the Fed will act until unemployment is significantly lower. What will they do if the market forces them to act? The real test of the Fed comes when they need to tighten monetary policy, but the economic and political climate are placing heavy pressure against such a move.

Fed Chairman Volcker faced this climate in the late 70’s and early 80’s when inflation was soaring, and he had the guts to make the right move. This caused short-term pain, but long-term prosperity. Will the current Fed do the same when its time comes? 

Who will fill the void now that the biggest buyer of new government debt is gone? Will foreigners continue to step up to the plate along with banks and the public? If market participants start to perceive that the U.S. obligations are nearing the tipping point, you will see rates rising ahead of Fed action. If and when this unfolds is difficult to assess. It could be in a month, a year, five or 20 years from now.    

Debt Ceiling Debate

As July unfolds, the debt ceiling debate will take center stage. The current fiscal path in unsustainable, and we will someday experience the Greek tragedy now unfolding if we fail to enact any reforms. The main reason why the current recovery has been so sluggish is due to the continued debt overhang. It will act as a drag on the economy until the bad loans and debt are mostly cleared out. The problem with enacting reforms is that it is not politically popular because no one ever wants their benefits cut (that’s why the Greeks are rioting).

The markets always like to be bailed out in the short-term to avoid pain and hard decisions, similar to how we might react with our personal choices. The government is always willing to reinforce this behavior out of political panic and opportunity. The average interest rate on Treasury borrowing is 2.5 percent. If rates were to normalize up from the Fed’s artificial level, it would add hundreds of billions to the annual interest expense putting more pressure on the deficit.

The President’s budget predicts over four percent GDP growth every year for the next three years. These growth figures are so overly optimistic and out of line with general consensus, they are laughable.   Missing these rosy economic projections by even a percentage point with the President’s proposed budget would add trillions to the national debt in just a few short years thereby exacerbating our debt situation.    

We are at an interesting crossroads where irony abounds. The healthiest situation for fiscal soundness is to enact reform now before it gets out of hand, but because it is not a problem now and requires some (very mild) short-term pain (i.e., entitlement reforms/cuts) there is not a great will to do so. In the short-term the bond market would like the debt ceiling raised to avoid any disruptions in payments of principal or interest. However, to continue to raise the debt ceiling without any real fiscal reforms will spell disaster for the bond market in the long-term. 

Picking Savers’ Pockets

If the government does not like to make outwardly hard decisions, how can they tackle the enormous deficit and debt overhangs? This is where you come in. The government does not need to tax you more outright or cut your benefits – that would be to obvious and politically unfeasible. According to economist Carmen Reinhart of the Peterson Institute for International Economics, the option then becomes what is called financial repression. Financial repression involves keeping nominal (i.e. published or quoted) interest on government bonds lower than inflation. It is basically a form of picking the pockets of savers, and it is already happening.

The Consumer Price Index as of the end of May was running at 3.6 percent. I am sure you are well aware of the rate you get on savings, which is pretty much zero. This means that your cash just sitting around or at the bank is worth 3.6 percent less than a year ago.  This spread directly benefits the government at your expense. It inflates away the value of the debt. This type of action for 10 years could reduce the Debt/GDP level by 30 -40 percent! Voila, it’s like magic! They just stealthily increased your tax burden without you directly noticing. You will feel it over time in the form of a lower standard of living where things just never really seem to get to where they were before.     

Although economic growth is slowing, it is still growth, and corporate profits are still very impressive providing support for further equity gains. All Congress and the President have to do is pass real fiscal reform along with the short-term debt ceiling increase, and the markets would smile.