"There is a sword of Damocles hanging over the head of every American. Sadly, it is about to drop."
Sorry for the drama, but I need to get your attention.
We know that the Fed has kept interest rates low for many years until recently. Why did it do so? Here are some of the reasons we have been told:
The Fed wanted to stimulate the economy.
The Fed wanted to make it easier for Americans to borrow.
The Fed wanted to create a "wealth effect" to encourage spending.
Which of these statements do you think explains the primary reason for the Fed's decision to keep interest rates low? Don't bother. It is none of the above.
The primary reason the Fed kept interest rates low was to avert an economic catastrophe. Today, that catastrophe can no longer be avoided.
The trigger for the economic explosion is the rising interest payments on the federal debt.
Let's go through the numbers.
During the eight years of the Obama administration, our total national debt rose from $12.3 trillion to $20 trillion while interest rates sank to a new all-time low. (The national debt figure includes money owed by the government to itself. The debt held by the public is what interests us since the government must pay out the interest to those bond holders.)
In 2009, the year President Obama took office, the national debt held by the public was $7.27 trillion. At the end of fiscal 2016, that had soared to approximately $14 trillion. Given that our marketable debt doubled from 2009 to 2016, it's remarkable that the annual cost of the interest on the debt rose far less, from $185 billion to $223 billion.
The long march of rising rates that began recently is a dramatic reversal after nearly 40-years of declining interest rates. The new trend portends a return to more historic rates. You may be asking: what are the historic rates? We calculate that the average rate paid on the federal debt over the last 30 years was close to 5%.
The non-partisan Congressional Budget Office (CBO) has just raised its estimate that debt held by the public will rise to $17.8 trillion in 2020. Some economists believe that the figure will be much higher. For our exercise though, let's stick with the CBO estimate. We are postulating that the interest rate on our national debt may return to the long-term, 30-year average of 5%. Note, too, that Treasury debt rolls over every 3 to 4 years so the maturing bonds at low interest rates will be refinanced at the then current higher rates.
Let's do the math together.
Take the CBO estimate of debt held by the public of $17.8 trillion in 2020, a 5% average interest on that amount comes to annual debt service of $891 billion, an unfathomable amount. (In 2017, interest on the debt held by the public was $458.5 billion, itself a scary number.) In its current report, the CBO added: "It also reflects significant growth in interest costs, which are projected to grow more quickly than any other major component of the budget."
Here's the danger:
According to CBO, individual income taxes produced $1.6 trillion in revenue in fiscal year 2017.
Under this 2020 scenario, over half of all personal income taxes will be required just to service the national debt.
Annual debt service in 2020 will exceed our newly increased defense budget of $700 billion in FY 2018.
Annual debt service would exceed our Social Security obligations.
Note: We are using fiscal year 2017 budget numbers for comparison. It is likely that all the numbers will be higher in 2020, but the proportions will likely be similar or worse.
These numbers are staggering, more so because the assumptions we use are reasonable and predictable. This dangerous trend is the consequence of our failure to pay enough attention to the national debt, and especially to the effect of rising interest rates.
What can we do about this coming crisis? As investors, we should prepare for higher inflation and higher interest rates. Investors should consider these moves:
Sell all medium and long-term bonds.
Consider diversifying into reasonable amounts of gold and selected commodities.
Buy TIPS (Inflation protected treasury bonds).
This last suggestion is an exceptionally interesting investment because these are U.S. Treasury bonds that adjust for inflation by adding to the principal every six months. So long as you buy the bonds at par, you will get all your principal back at maturity, even in the unlikely event we have a long bout of deflation. On the upside, if there is a spike in inflation, these bonds could increase substantially in value, a welcome and unusual occurrence for a bond guaranteed by the U.S. Treasury.
In time, the responsibility for solving the crisis will fall on the Administration and Congress, who have successfully ignored this predictable problem for years.