Debt and spending coming home to roost
Feb. 6 (Bloomberg) -- President George W. Bush has increased the national debt 45 percent while cutting the share of the budget spent on interest by almost a third. That's about to change as borrowing costs go up.
Bush benefited from the combination of economic expansion, low interest rates and strong foreign demand for Treasury securities as the national debt ballooned to more than $8 trillion from $5.6 trillion at his inauguration in January 2001. Declining rates allowed interest expense to drop to 14.2 percent of the budget in fiscal 2005 from 20.2 percent in fiscal 2000.
``Up until now, rising debt has been offset by a falling interest rate,'' says Brad Setser, an economist at Roubini Global Economics in New York. ``Now, debt is still rising and the interest rate is no longer falling. The consequence of rising debt will no longer be masked.''
The Treasury's interest costs are poised to jump after the Federal Reserve's 14 consecutive rate increases, a record supply of U.S. debt and signs that international investors are losing their appetite for U.S. government securities, say strategists such as Chris Rupkey of Bank of Tokyo-Mitsubishi and Lou Crandall of Wrightson ICAP LLS, both of them based in New York.
``Federal interest costs are rising very rapidly,'' Crandall says. ``Much of the debt that the government issues is short-term debt, and that's all being repriced at progressively higher interest rates.''
About 23 percent of the Treasury's $4.1 trillion in marketable securities matures in less than a year, and almost half matures in three years or less. Only 12 percent are 30-year bonds, the smallest percentage since at least 1980, according to Treasury figures. This week the Treasury is selling $14 billion in 30-year bonds, the first to be offered by the U.S. government since August 2001.
Bush will present Congress today with a fiscal 2007 budget that the Congressional Budget Office estimates will have a deficit of at least $270 billion before adding on costs of the war in Iraq and rebuilding of the Gulf Coast after last year's hurricanes. CBO projects the deficit for fiscal 2006, which ends Sept. 30, will widen to as much as $360 billion from last year's $319 billion.
Bush has boosted federal discretionary spending more than any president in the last 40 years on an inflation adjusted basis, according to the Cato Institute, a Washington-based research group that advocates low taxes and small government.
Interest expense on the federal debt was $352.4 billion in the fiscal year ended last Sept. 30, compared with $362 billion in fiscal 2000. An increase in the government's interest costs to 21 percent of the total budget, the level that prevailed through most of the 1990s, would add $200 billion to annual interest expenditures, according to CBO figures.
Higher Yields Forecast
The CBO forecasts that 3-month Treasury yields will rise to an average 4.5 percent in 2007 from 2.7 percent in 2005, while 10-year yields will average 5.2 percent next year, up from 4.2 percent last year. If Treasury sells the same $89 billion in 10- year notes in 2007 that it did in 2005, interest expense will be $900 million higher each year on those notes alone.
If interest rates are 1 percentage point higher than CBO's forecast, interest expense would rise $10 billion, the budget office said.
``The major run-up in borrowing from 2001 to 2003 is coming home to roost,'' says Stephen Stanley, chief economist at RBS Greenwich Capital in Greenwich, Connecticut. ``Even if the deficit is roughly stable over the next several years, Treasury will have to borrow more.''
Investors became more pessimistic about the $4 trillion Treasury market in January, a JPMorgan Chase & Co. survey showed. JPMorgan's sentiment index fell to minus 34 in the week ended Jan. 31 from minus 20 on Dec. 20, the last survey done in December.
The first signs of higher borrowing costs may come this quarter with the sale of a record $188 billion of Treasury securities. That may cut the price of government debt and boost the interest the Treasury has to offer to make the securities attractive to investors.
This week, the Treasury is selling $48 billion worth of notes and bonds and $37 billion in bills, which will bring the government close to the $8.14 trillion debt limit set by Congress. Treasury Secretary John Snow has asked Congress to boost the limit so the government can continue to fund its operations beyond mid-march.
``The huge amount of new Treasury debt on tap could be the factor that sends bond yields soaring,'' Rupkey says. ``Foreigners have had an insatiable appetite for U.S. securities, and this demand has helped to explain the low-yields. But even these overseas investors may not be able to take down all the debt that the Treasury is offering.''
Treasury yields have been held down in part because of demand by overseas investors, including foreign central banks that use dollars as their reserve currency. Investors abroad held $2.17 trillion of the $4.19 trillion of marketable U.S. securities outstanding in November.
Snow says he's confident higher debt costs won't be a burden on the federal budget. ``Borrowing costs still by historical standards are at the lower end of the historic range and the will continue to be at the lower end of the historic range,'' he told reporters last week in Pennsylvania. ``There will be some increase as indicated by the rising debt level, but interest rates continue to be low by historical standards.''
`Not a Big Thing'
If rates rise to slightly higher than 5 percent, ``it's not a big thing,'' says Charles Schultze, a senior fellow emeritus at the Brookings Institution in Washington.
Even as the Federal Reserve has raised its target overnight rate since June 2004, the yield on the 10-year Treasury note dropped to 4.51 percent from 4.68 percent.
After the Fed's latest rate increase, on Jan. 31, 10-year yields jumped to the highest since early December. On Feb. 3, 10- year notes yielded 4.53 percent.
Traders are pricing in an 88 percent chance the Fed will raise its benchmark rate to 4.75 percent at its next meeting on March 28, up from 46 percent on Jan. 5, according to interest- rate futures. Traders raised bets on the odds of an increase at the following meeting on May 10 to 38 percent, from no chance at the end of last week.
The Cato Institute's Stephen Slivinski says the likeliest prospect is for more borrowing that will push interest costs even higher. ``The short-term budget is exacerbated by interest costs going up,'' says Slivinski, director of budget studies at the Washington-based research organization. ``There's no specific policy, or interest in saying, `If we have higher interest payments we need to cut the budget elsewhere.'''
-- With reporting by Alex Tanzi in Washington and Elizabeth Stanton in New York. Editor: Rohner (scc)
To contact the reporter on this story: Alison Fitzgerald in Washington at Afitzgerald2@bloomberg.netLast Updated: February 6, 2006 00:17 EST