Earlier this decade, homeowners learned the hard way what happens when cheap and easy credit dries up. Unfortunately, the lessons of Main Street haven't filtered through to Washington -- and both taxpayers and investors will be left holding the bag.
Waiting for the inevitable
For more than a year now, short-term rates have stayed at rock-bottom levels. The Federal Reserve cut the fed funds rate in December 2008 to its current target between 0% and 0.25%, and it hasn't budged since. Despite concerns that leaving the rate so low would lead to a falling dollar and leave open the possibility of inflation, the Fed still shows no signs of raising it in the near future.
Based on past history, it's fair to assume that the Fed merely wants to ensure that the economy is truly on the path to a sustained, strong recovery before tightening monetary policy. Yet there's another big reason why keeping rates low has become extremely important. Unfortunately, it's a problem that could cost trillions of dollars to get resolved.
How to run the Treasury
With a multitrillion-dollar debt to finance, the Treasury has a tough job. It not only has to raise money, but also needs to figure out how exactly to position its debt portfolio to minimize the government's borrowing costs.
The problem, though, is that with borrowing, short-term needs are sometimes in conflict with what's best for the long term. Just as homeowners got trapped by attractive adjustable-rate mortgages whose payments skyrocketed after those teaser rates expired, so, too, has the government become increasingly addicted to cheap interest-rates on short-term paper. Here are the ugly facts:
- As of the end of March, the Treasury had $1.84 trillion in short-term Treasury bills that will come due within the next year. The yields on those borrowings range from 0.055% to 0.545%.
- A bit less than $700 billion in Treasury notes will also come due by March 31, 2011.
- Add that together, and you get over $2.5 trillion due within the next year -- out of a total of around $7.75 trillion that the Treasury has issued in marketable securities.
Keeping a third of your borrowings in short-term paper is a huge bet on rates staying low. As long as the Treasury can roll over that $2.5 trillion at current rates -- right now, three-month bills yield just 0.16% -- then things will remain relatively fine.
But at some point, rates will rise. Just three years ago, the government had to pay more than 5% on three-month Treasuries. If a five-percentage-point hike happened now, then the Treasury's borrowing costs on that $2.5 trillion would rise by $125 billion a year -- each and every year that rates were high.
One reasonable suggestion would be to lock in long-term rates now, especially if you think rates are due to rise across the board. But if you do that, then you'll have to pay between 3.7% and 4.6% on debt maturing between 2030 and 2040. That would basically lock in an assured $1 trillion rise in interest payments over the next 10 years.
Hurting corporate America
The problem isn't limited to the government, either. Many companies have borrowed huge amounts via short-term commercial paper at low rates. Here's what the same five-percentage-point rate hike could do to the interest expenses of some of the biggest borrowers in the S&P 500:
|
Company |
Commerical Paper Outstanding |
5-Percentage-Point Rate Hike Increases Annual Financing Costs by: |
Net Income, Trailing 12 Months |
|---|---|---|---|
|
General Electric |
$49.7 billion |
$2.5 billion |
$10.4 billion |
|
JPMorgan Chase |
$46.6 billion |
$2.3 billion |
$10.2 billion |
|
US Bancorp |
$14.6 billion |
$730 million |
$2.0 billion |
|
Ford Motor |
$6.4 billion |
$320 million |
$2.7 billion |
|
Coca-Cola |
$6.3 billion |
$315 million |
$7.1 billion |
|
Caterpillar |
$2.4 billion |
$120 million |
$895 million |
Source: Yahoo! Finance; Capital IQ, a division of Standard and Poor's.
Those higher costs will take a considerable bite out of these companies' earnings. And that's only looking at the shortest end of their debt structures. Most of these companies, along with hundreds if not thousands of others, will also have longer-term debt coming due in the near future that will have to be refinanced.
Adding to the pile
Furthermore, none of this analysis considers the huge budget deficits we're running right now. Those deficits will need financing as well -- and the huge supply of future Treasuries could push interest rates higher still.
In that light, Fed Chairman Ben Bernanke's calls for meaningful budget deficit reduction make sense. Until the government gets its finances under control, Bernanke's job -- along with Treasury Secretary Tim Geithner's -- will just keep getting harder. And from an investor's perspective, you'll want to make sure the companies you invest in can handle their debt no matter what happens to rates in the future.
What's your solution to the Treasury's addiction to low rates? Sound off in the comments below.
