US Budget Projected Interest Rate Sensitivity Analysis: Quantifying The US Default Buffer
It has long been discussed, both on Zero Hedge and elsewhere, that the massive budget deficit over the next 10 years will have to be funded with an unprecedented amount of new Treasury issuance. Various estimates project that absent a dramatic increase in yields, especially in the mid and longer dated side of the curve, there will simply not be enough demand for treasuries to fund the budget shortfalls just in the upcoming year (let alone the next ten). Furthermore, it is known that governmental estimates put early to mid 2011 total US debt estimates in the $14 trillion ballpark, courtesy of the just signed into law debt ceiling raise to $14.3 trillion. Lastly, the Treasury has made it well known that it intends to push debt issuance away from Bills and into Bonds and Notes, with the goal of increasing the average maturity of new debt to 5-6 years, which also would inevitably increase the average cost of Treasury borrowings as existing debt, of which 40% matures in under a year, has to be rolled into longer-dated debt. We present a recent monthly analysis of core Treasury receipts and outlays, highlighting the minor role that interest payments play currently. Yet should there be a dramatic or even gradual increase in rates, the monthly cost of funding of the ever increasing debt burden will soon become unbearable. A black swan scenario, which introduces an average interest rate reversion to those dark early 1980's days, when USTs carried interest of 10% and over, will see a 424% increase in monthly interest expenditures, which will push the annual interest expense as a percentage of core Treasury Deposits from the current 10% to nearly 50%, plunging America into a debt funding spiral.
First, we present monthly core treasury receipts and outlays. It should come as no surprise that over the past 18 months the Treasury has seen a net inflow based on core items just 3 times. For the purposes of this analysis we define "core" as Withheld Income and Employment Taxes and Corporate Income Taxes as the main UST receipt items, and Defense Vendor Payments, Education Department Programs, MedicAid and Medicare, Social Security Benefits, Unemployment Insurance Benefits and Interest on Treasury Securities as the main UST outlays. The chart below summarizes the progression of the composition of these core items since October 2008. We have yet to see a net inflow month since March 2009, primarily due to still collapsing tax receipts.
As can be seen on the chart above, the light-green shaded area, or the Interest paid on Treasury Securities, has been a minor portion of total UST outlays. The reason for this is the record low interest rate on Treasury Bills (we have experienced 4-week Bill auctions pricing at 0.000% on many occasions over the past several months), which comprise nearly half of all US marketable debt, the portion of debt which sees actual interest outlays instead of just intragovernmental cash flows, which is the case when observing the $4.5 trillion in various Trust Funds and Intragovernmental Holdings on the UST's books.
Focusing on interest payments, it becomes obvious that even as debt has hit all time record highs, the blended rate on LTM interest outflows has hit record lows. The chart below demonstrates the actual LTM cash interest paid over the past 28 months. As the trendline indicates, the prevailing interest payments have been declining!
Why is this perplexing? Because as the chart below highlights, the marketable debt holdings of the Treasury have been surging without pause to a January level of $7.8 trillion from $6.3 trillion in October 2008: a $1.5 trillion increase in marketable debt holdings in a little over a year. Yet, when calculating interest payment outlays on an LTM basis, and backing into what the implied interest rate on the marketable debt is, one sees the paradox: the as calculated interest rate on the surging debtload has declined from over 2.6% in 2008 to 2.2% presently.
The primary reason for this: the stable yields on the Treasury curve over the past year courtesy of the Fed purchasing not only $300 billion of Treasuries but also $1.4 trillion in MBS and Agency securities, which has kept the fixed income market calm since Quantitative Easing was introduced. Furthermore, the record curve steepness means that the Treasury is paying virtually no interest on 40% of its holdings. This spread divergence can be seen on the following FRB Atlanta chart:
So as we enter the stratosphere of debt holdings over the next 12 months and as we approach the $9 trillion marketable debt threshold by early 2011, what do rate assumptions tell us?
Well, if all is fine and good, and the Fed continues to monetize securities (USTs., MBS, etc.) past March, and over the next 12 months, there will be a constant bid under the "low-risk" Fixed Income complex. This means that the current blended rate of 2.2% will probably persist. Yet what happens if there is an interest flare event? What happens if not only Morgan Stanley is right and 10 years hit 5.5% (with 30 year MBS hitting 7.5%), but a feedback loop takes rates much, much higher, to those anathema days of Paul Volcker, when getting a loan below 10% was considered luck?
We present a table summarizing the probable outcomes below.
We believe the "Low" case is unrealistic as there is no way that an incremental $2 trillion in UST issuance will not move rates higher. Therefore we believe the Medium case is really the realistic downside rate case. In that case, the average monthly interest payment will increase from $14.3 billion to $24 billion: a 67% increase. It will also represent 16% of total Treasury receipts, compared to the current sub 10%. This is 6% that could be going to education, healthcare, defense or many other "core" programs.
Yet the scenarios that trouble us are the "High" and "Catastrophe" a/k/a Black Swan, cases. If MS is correct and 10 rates reach 5.5%, if the curve flattens, and if the UST manages to extend the average maturity well into the 5-10 year bracket, the 5% interest rate scenario is all too realistic. In this case, Interest payment will grow to an alarming 25% of all monthly receipts, while the average monthly interest outflow will reach $38 billion, a 162% increase.
Finally, if the low probability "Catastrophe" Projection Case comes through, Japan, here we come. Should prevailing Treasury rates somehow hit 10%, the average monthly interest outlay will reach $75 billion, a 400%+ increase from current outflows, and the Annual Interest expense as a % of LTM Core UST receipts will hit a stunning 50%! This means that the Treasury will spend 50% of all tax receipts merely to cover interest expense. And this assumes that the Trust Funds on the UST's balance sheet are not converted into actual outflow generating securities (more on this topic in a later post).
A full two-dimensional sensitivity analysis also takes into consideration the only real natural source of cash for the Treasury (aside from financings): tax receipts, both individual and corporate. We have demonstrated previously the dramatic deterioration in Treasury tax withholdings. The continued persistence of this trend is the single biggest nightmare for the Administration, as one can only finance budget shortfalls for so long, as tax receipts decline. The current combined LTM Treasury tax receipts (gross, not net of refunds) amount to $1.8 trillion. Should this number decline further, due to the administration's heavy handed approach in appeasing the electorate at the expense of the relevant tax payers (i.e, the richest 10% of the population which pays the bulk of the nation's taxes), and should increasing numbers of US taxpayers flee to overseas tax havens, there is legitimate case that should interest rates skyrocket, then the US Treasury could see 100%+ of all tax revenues going simply to cover interest expense. As anyone remotely familiar with economics or finance is well aware, this would be the end for America. In other words, we currently have a buffer of $400 billion in tax receipts declines, and about 10% in interest rate increases before America is officially bankrupt.
While the realistic outcome over the next 12 months will likely be between the Medium and the High cases, it implies that ever more tax dollars will have to be used simply to cover interest payments to both domestic and foreign creditors. And should the liquidity and funding crisis in Europe escalate, and the hatchling Black Swan migrate across the pond, causing a spike in Treasury Interest Rates, then what pundits lament about Japan's debt spiral will promptly be forgotten, as it becomes an all too real phenomenon not across the Pacific but here in our own country.