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For years, the U.S. government has gotten lucky. But how long can the good times last before someone has to pay the piper?
During the recession and the financial crisis, most people agreed – reluctantly, in some cases -- that increasing the national debt in order to provide a stimulus to the U.S. economy was necessary to prevent an economic catastrophe. The resulting increase in both the overall debt and annual budget deficits since then has been dramatic. Yet the full impact of those moves remains to be seen, and when it comes, it could be devastating to companies in many industries.
The national debt and interest rates
Many people understand firsthand just how valuable low interest rates have been. While low rates have hurt savers, borrowers have seen huge reductions in their financing costs. In particular, those who've been able to refinance their mortgages at much lower rates have saved thousands in interest costs, in many cases allowing them to shorten the length of their loans to get their homes paid off faster.
But the magnitude of individual savings from lower rates pales in comparison to what the U.S. government has saved. As a recent article in The New York Times discussed, the amount of interest that the government has to pay to service its debt has remained relatively constant over the past five years -- even though the total amount of debt has skyrocketed, more than doubling over that timeframe. The government's total effective interest rate has fallen from nearly 5% in 2006 to just under 2.25% last year.
What comes down must go up, right?
Skeptics wonder how long the good times can last for U.S. sovereign debt. With the Federal Reserve employing all the weapons at its disposal to keep rates down, unprecedented investor demand has helped keep Treasury rates low. But even a modest rise in rates could send interest costs soaring, pushing the national debt into an upward spiral.
If that happens, it would mean less money for spending on other government expenditures. In particular:
- Defense spending could see further slashing, making recent cuts look modest by comparison. Boeing (NYSE: BA ) and other large contractors might well survive relatively well, especially those that have extensive non-military businesses. But smaller companies AeroVironment and Oshkosh (NYSE: OSK ) , which got hit hard in the recent round of cuts, could suffer even more harm in an even tighter budget environment.
- Hospital companies Health Management Associates (NYSE: HMA ) and Tenet Healthcare have already been under pressure from the threat of Medicare reimbursement policy changes. Budget cuts could make reimbursement reductions a real possibility, dampening investor sentiment over what most see as a demographically promising sector of the economy.
- The government's role in facilitating housing loans through government-sponsored enterprises Fannie Mae and Freddie Mac could get scaled down. That in turn would make it harder for mortgage REITs Annaly Capital (NYSE: NLY ) and American Capital Agency (Nasdaq: AGNC ) to take advantage of low rates to make leveraged bets on home loans, as the disappearance of an implied federal guarantee of such loans would make mortgage REITs much more risky.
Moreover, these are just examples of some direct effects from cuts. Second-order effects that might arise from tax increases to try to trim deficits could have an even bigger impact on a large cross section of the entire U.S. economy.
Are we doomed?
The question is whether higher rates are in fact inevitable. In Japan, the debt situation is even worse in terms of percentage of GDP. Yet Japanese bonds still carry some of the lowest rates in the world -- and have consistently done so for the past two decades.
Still, few would say that Japan is a model the U.S. should emulate. The better solution to avoid a potential debt catastrophe is to take steps now to get the government budget back under control -- even if those steps don't take effect immediately. Just getting a framework in place would be a huge improvement over the current untenable situation.
What do you think about the potential for budget Armageddon? Tell us what you think in the comments box below.