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On October 5, 2023, Treasury Secretary Janet Yellen made a very telling statement about the future course of interest rates:
Yellen Says Debt Service Costs Will be 1% of GDP for the Next Decade – Reuters
Her statement implied that the economy will be strong with budget surpluses, or interest rates will be near zero for the next 10 years.
Instead of guessing what she is pondering, I did some math and arrived at the only possible answer.
The government can't afford today's interest rates
Before walking through various scenarios to figure out what Yellen was implying, it's helpful to provide background on what drove her mindset. In my article, The Government Can't Afford Higher For Longer, Much Longer, I shared the following graph and commentary:
Total federal interest expenses should rise by approximately $226 billion over the next twelve months to over $1.15 trillion. For context, from the second quarter of 2010 to the end of 2021, when interest rates were near zero, the interest expense rose by $240 billion in aggregate. More stunningly, the interest expense has increased more in the last three years than in the fifty years prior.
The graph above tells a small part of the fiscal deficit story. Every month, lower-interest-rate debt matures and will be replaced with higher-cost debt.
Higher interest rates are an additional funding burden for the federal government. Janet Yellen surely understands the damaging situation and grasps that higher interest rates are not feasible given current debt levels.
Low-interest rates make debt manageable
The federal debt-to-GDP ratio has climbed three-fold since 1966. Yet, until very recently, the ratio of the federal interest expense to GDP was at its lowest level since that year, 1966.
While the amount of debt rose sharply, its cost was offset by rapidly falling interest rates. As a result, higher debt levels were very manageable.
If $1 trillion of debt with a 4% coupon matures and is replaced with $2 trillion at a 2% coupon, the interest expense doesn't change despite doubling the debt. While a simplified example, that is essentially what has occurred for the last 30 years.
The following graph compares the yield of the five-year U.S. Treasury note and the implied cost of funding the government's debt.
But as lower-interest-rate debt is replaced with higher-interest-rate debt, the benefits of lower rates work in reverse.
Debt service costs at 1% – Is it possible?
We return to Janet Yellen's message and walk through scenarios of how she might be proven correct.
Balanced budgets and unicorns
In the five years leading up to the pandemic, nominal GDP grew at 5.03% annually. Let's optimistically assume growth continues at 5% consistently for the next 10 years. Let's tack on an even bolder presumption: The government balances its budget every year for the next 10 years. Thus, the amount of outstanding debt will remain constant. For context, in the last 57 years, there has only been one year in which the amount of debt has not increased.
In such a far-fetched scenario, the debt-to-GDP ratio would drop considerably to 70%. But interest costs would equal 2% of GDP. Such is much better than the current 3.36% but double Janet Yellen's 1% objective.
Budget surpluses for the next 10 years would lower interest expenses even more and possibly get the interest expense to GDP ratio to 1%. But the odds of a unicorn spraying rainbows across the sky and the government running a surplus are the same: zero percent.
Consequently, I exclude surpluses as a viable way to reduce the interest expense to a more manageable level.
Budget deficits and the magic of low-interest rates
Balanced budgets or surpluses are unrealistic, given the political and fiscal trends. Further, the economy relies heavily on government spending. While fiscal prudence would be good in the long run, the short-run effect would be a reduction in GDP and a recession.
Instead of using pipe dreams as scenarios, let's get realistic. The more likely, albeit still optimistic, scenario involves the debt and GDP growing at the same rate as each other. Let's also assume interest rates remain at current levels. In this exercise, I assume an average borrowing cost of 4.75%, which is a little below the current weighted-average funding cost for the government. Under this "realistic" picture, interest expense would climb to 5.6% of GDP.
The only variable in the equation that can make Janet Yellen correct is the future interest rate.
To arrive at Yellen's 1% figure, assuming debt grows at the rate of GDP, interest rates must be much lower.
In time, a weighted-average interest rate of 0.85% would put the nation's interest expense at 1% of GDP.
When Janet Yellen tells us that the debt-cost-to-GDP ratio will be 1% over the next 10 years, she is really saying interest rates will be below 1% for the next 10 years.
Therefore, Janet Yellen must believe that the recent spikes in inflation and yields were an anomaly. She will be proven accurate if the pre-pandemic economic and interest rate trends resume.
Summary
Part of Yellen's job is to exude confidence to investors. In this case, it means telling the public that the current jump in interest expenses will not last. While she would probably prefer to be straightforward and say interest rates will be much lower, she must also be sympathetic to the Fed's job of getting inflation down. Therefore, to walk the party line she must speak in code, so to speak.
Whether you agree with Yellen's projection or not, the following CBO graph projecting interest costs as a percentage of tax revenues, courtesy of Bianco Research, highlights that the government has no choice but lower-for-longer interest rates. The current level of interest rates will bankrupt the nation.
Michael Lebowitz is a portfolio manager with RIA Advisors and author for Real Investment Advice. For more information contact him at [email protected] or 301.466.1204.
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