It is a question we are all asking ourselves as the national debt approaches $20 trillion with Donald Trump about to occupy the White House and planning a $1 trillion infrastructure program.
Interest rates are climbing all across the yield curve having just been exacerbated by Thursday’s overnight funds rate hike by the Federal Reserve Board. How high can interest rates go before the debt is unsustainable? More precisely, how high before interest expense plus mandatory spending take up the entire federal budget?
Or even scarier, how high can interest rates theoretically go before interest expense eats up all tax receipts entirely? I will be making some assumptions in these calculations. First, I will be keeping the deficit constant. Second, I will be keeping tax receipts constant for simplicity. The results will be an imprecise number, but we will still get a ballpark.
At the point where interest expense takes up all discretionary spending, the Fed will have come up against a brick wall and will have to sacrifice the dollar in order to keep Washington solvent. That means taking purchasing power from citizens and giving it to Washington, essentially appropriating value from the currency at the expense of consumers. Alternatively it can bankrupt Washington and keep the dollar intact.
We'll go through each maturity separately, but in order to get a decent handle on the U.S. government bond market with a single proxy indicator, those interested can track the iShares 7-10 Year Treasury Bond ETF (ARCA:IEF, Financial).
First, let’s take a look at interest rates across the yield curve starting with the two-year out to 30-year and compare them with pre-2008 financial crisis highs, the crisis that pushed the Fed into moving rates as close to zero as possible.
All maturities are now exploding higher at some of their fastest rates ever. Here’s the two-year, which has increased 650% since bottoming in September 2011 at just 0.17%. We are now at 1.27%; 120% of that run has occurred since July 7. Pre-2008 financial crisis, the two-year yield hit just above 5%.
Here is the five-year, which has just broken the 2% mark after bottoming at 0.59% in July 2012. That is a rise of 242%, 113% of that since July. Pre-2008 financial crisis, the five-year hit 5.05%.
Moving to the 10-year, which hit a low of 1.37% this July and is now at 2.54% for a rise of 85% in five months. In 2007 this rate hit 5.26%.
Two more to go. Moving out to 20 years, this one at the end of the yield curve has risen 70% since bottoming in July. These rates hit 5.34% in 2007. Finally, at the end of the curve at 30 years, we saw a bottom at 2.14% in July, now 3.14% for 100 basis points, or 47% in five months. 2007 saw these rates also at about 5.3%. You will see a pattern here that rates across most of the yield curve back in 2007 were nearly the same, which is why the yield curve was pretty flat back then, which in turn contributed to the oncoming recession.
What is the point of all these numbers? Simply this: According to the U.S. Government Accountability Office, interest expense on the national debt in 2007 totaled $433 billion. Total gross federal debt outstanding at the end of that year was $9 trillion, or $8.993 trillion to be exact. Today, end of 2016, interest expense on the national debt is remarkably nearly exactly the same at $430 billion, with interest rates much much lower than they were in 2007. Total gross federal debt outstanding today is $19.94 trillion and counting, which if we round the numbers and compare $20 trillion to $9 trillion is 122% higher.
Federal spending is at $3.9 trillion. Let’s keep that constant for simplicity, even though it may increase under Trump. Mandatory spending, which includes mainly Social Security, Medicare and other programs, is now at $2.6 trillion. That leaves $1.3 trillion in discretionary spending assuming a steady deficit, which again is not a given.
We have seen that interest rates were about 5% across the board from two-year to 30-year back in 2007, more or less. That resulted in interest expense of $433 billion. If we take $9 trillion and multiply it by .05, we get $450 billion, so roughly the numbers work. If interest rates were to climb to 2007 levels, which we’ll just round to around 5% across the yield curve which is practically where they were, then we have .05 multiplied by $20 trillion, which comes out to a neat $1 trillion in interest expense. That leaves only $300 billion in discretionary spending, assuming a constant deficit.
So how high can rates go before everything is eaten up by mandatory spending and interest expense? About 6.5% across the board to eat up the remaining $300 billion. Seem impossible? Not quite impossible. These rates are considered “normal” and indeed these were the prevailing interest rates at the turn of the century across the yield curve.
As for the second question, at what point will all Federal tax receipts be eaten up by interest expense alone so that every single penny spent on anything else is literally borrowed? Annual federal tax revenue is currently about $3.3 trillion. That translates to rates of about 16.5% across the board. Does that seem impossible as well? Not quite impossible. Indeed, we have actually been there before.
Here’s the two-year again, longer term chart. Notice the text box centered on 1981:
And the five-year:
And the 10-year:
And even the 30-year:
While interest rates approaching 16% seem way out there, it has happened, and it was at the behest of the Federal Reserve itself which raised the effective Fed Funds rate to above 19% in order to save the dollar at the time. So in the end, something’s gotta give. There are only three options: The budget is cut massively, the dollar hyperinflates, or the federal government declares bankruptcy. 2007 level interest rates at constant tax receipts should be enough to force a choice between those three options.
Disclosure: No positions.
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