The Wild Card In Federal Budget Projections - Every Note Auction Could Land On Double Zero

I have a doubling system that that leads to making money at the roulette table nine times out of ten. However, despite the fact that this system makes a gambler utilizing it a winner 90% of the time, the casino's love my system. The reason casinos love doubling systems is because when they fail, the losses are catastrophic. So despite the fact that my doubling systems wins 9 times out of 10, the more often it is used, the more money the casino's ultimately make. Thus, even though a gambler that utilizes this system knows they are going to make money most of the time, they also have to be aware that going to the table too many times guarantees a bad outcome.

It may be a weak analogy, but every U.S note and bond auction reminds me of a gambler that goes to the roulette table one too many times.  Sooner or later, the result is going to be catastrophic. Every Treasury auction required to raise funds to fill the trillion dollar deficit hole and to refinance the maturing notes and bonds from the $15 trillion debt increases the probability of a failed auction by a tiny bit. Given that there are now typically four or five note or bond auctions every month, it seems like the U.S. Treasury is making an awful lot of trips to the table.

So far, my fears have been totally unfounded. I had to go back and double check the results of the yield curve from the most recent Treasury auction as upon first glance the interest rates seemed impossibly low. As of 11/15 the 10 year notes are only yielding 2.06% and the 30 year bonds are only yielding 3.1%:

Daily Treasury Yield Curve Rates   

 

Based on the results of recent Treasury auctions, is is probably premature to fear that the note auctions on 11/21, 11./22, 11/23 will signal the start of an upward spiral in interest rates. The average yield on total U.S. debt has been decreasing while at the same time, the Treasury Department has been able to lengthen the average maturity of U.S debt during 2011. Thus, at least in the short term, the risk of a fiscal crisis is minimal. However, I am not sure the same can be said about the auctions two and three years down the road.


The huge risk to the U.S. economy comes into play in a couple of years if investors and sovereign governments start demanding better returns in order to fund the huge and growing deficit. The Congressional Budget Office (CBO's) is projecting that interest rate on the 10 year Treasury note will be 5.5% during 2015 through 2020. Even at 5.5% interest rates and with rosy projection about unemployment and GDP growth, the CBO is projecting that that the nominal cost of interest payment to fund the debt will triple by 2020. However, if the CBO's optimistic projections for 2012-2014 of 6.5% unemployment and 4.4% growth in GDP fail to come to pass and interest rates required to attract buyers for at debt auctions go significantly higher than 5.5%. then the exponentially growing U.S. debt burden will spiral into a fiscal crisis.

What interest rate will be required to fund the U.S. debt in 2015?

If it is today's rate of  about 2.0%, the U.S. economy will be fine

If it is the CBO's projected rate of 5.5% the U.S economy can probably muddle through

If it is a 7% rate, similar to the cost to Italian's to sell their 10 year notes, the U.S. may experience a fiscal crisis and quite likely head into an economic depression

If it is above 10%, as it was in the late 70's and early '80's the results will be catastrophic for the U.S. economy 

Conclusion

Making accurate projections about the size of U.S. budget deficit over the next few years and its impact on the economy requires getting the interest rates required to fund the debt right. If the optimistic assumptions of the CBO about the world's willingness to continue funding our profligate spending turn out to be wrong, the U.S. is headed for an economic calamity. 

An upward spiral in interest rates could begin at any one of the increasing frequent Treasury auctions. The risk grows dramatically in the next few years as the size of the debt burden gets ever larger.