Why The AAA Rating of U.S. Debt Is In Jeopardy

Over at Creditwritedowns, Edward Harrison posted a chart taken from a recent article in Die Welt showing the indebtedness of the U.S and the other nations with AAA rated sovereign debt. Glancing at the numbers shows that the U.S. has both the worst debt and deficit ratio to GDP of any nation that has maintained a AAA rating. This data clearly illustrates why the AAA rating of the U.S. is in danger. As the ratio of debt to GDP increases, so does the risk to bond holders. 


For reference, the downgrade of U.S debt by one of the ratings agencies, Standard & Poors, had no impact on interest rates, so a downgrade by itself  will not result in higher yields being required to sell U.S. issued debt.  Despite the S & P downgrade, U.S debt is still considered AAA because it still maintains that rating from other ratings agencies. But if they all downgrade the U.S. debt, the AAA rating will be lost. A failure by the Deficit Super Committee to come up with a plan to reduce the deficit could lead the other rating agencies to reconsider whether the U.S. debt really deserves a AAA rating.  

Unfortunately, a continued stalemate by the Deficit Super Committee could have serious consequences for the cost of funding U.S debt if their inaction leads to: 1) the AAA credit rating of the U.S. being downgraded; and 2) a loss of confidence in the perceived value of U.S issued debt. Given that $11 billion dollar of TIPS are being offered today and $99 billion in notes are being auctioned on 11/21-11/23, even a slight increase in the yield required to sell the bonds will cost U.S. taxpayers dearly. Just a 0.1% increase in the average yield would increase the annual interest payments on this debt by $10 million.

Is Punting On Keystone XL Pipeline Deal Propelling Oil Over $100 Per Barrel

The price of oil was trending upward prior to the November 11 announcement that a decision on the Keystone XL Pipeline would be delayed until after the 2012 election. Given the tight supply, increasing demand, and turmoil in the Mideast, the price of oil may very well have broken through the $100 per barrel barrier regardless of the Keystone XL decision. However, this decision symbolizes America's lack of will to reduce our dependence on imported oil.

The U.S. need to import 9 million barrels of oil per day to satisfy our energy requirements puts the economy at risk. Expensive oil impacts the U.S. economy in myriad ways. It is even arguable that the positive economic numbers in the 3rd quarter were largely due to the drop in the price of oil. A case can also be made that many of the rosy economic projections that have been published lately are badly flawed due to not giving sufficient weight to the negative impact of increasing oil prices.

Thus, although the Keystone XL decision may not be a factor in oil rising above $100 a barrel, it is endemic of the type of policy decisions on energy that puts the U.S. economy at risk. As new supplies of oil become increasingly expensive to access and worldwide demand goes up, there is likely to be long term upward momentum for continued increases in the price of oil. The huge and dependable ongoing demand for imported oil from the U.S. is one of the pillars providing support for the high prices.

The ultimate irony of the decision to delay a decision on the Keystone XL Pipeline is that not building out this project has environmental drawbacks, as outlined in a Grist article. In a worst case scenario, it could actually end up leading some utilities to replace expensive oil with cheap, dirty coal.

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. 

Occupy The Boardroom is Naming Names

I am not sure quite how to react to the tactic of OccupyTheBoardroom.org  of naming the names of the board members of the "too big to fail" banks. Frankly, publishing publicly available information and suggesting that these individuals be buried with e-mail seems fairly innocuous. However, given the anarchistic fringe  of the Occupy movement, and the popularity of a video that advocates a French style revolution (over 100,000 views), this website somehow seems a bit sinister. I am probably overreacting in regard to this content that suggests an action that is significantly less intrusive than setting up an unauthorized, unsanitary campground, but it does to have the potential to lead to unintended consequenses

Another aspect of the website that is worthy of attention is its summary of a message that succinctly captures the populist anger held by a broad range of U.S voters.


"Make your voice heard by the Wall Street elites who wrecked the economy and made the rest of us pay. Click on someone below and tell them a story that you think they should listen to. Just got a college degree and nothing to show for it? Just got evicted while your banker gets bonuses? Share your special story with someone who ought to know."

It seems to me that those favoring fiscal sanity should consider if it is appropriate to tap into the above populist message in order to gain support for measures to bring the trillion dollar U.S. annual deficit under control. While it is ridiculously over simplistic to blame the Great Recession on Wall Street elites, the question of whether targeting this group is pandering to the mob or just smart politics is worth asking.

Should Deficit Hawks Favoring No Tax Hikes Be Paying Attention to Labor Strikes in Greece?

The economic question of whether the U.S. can close the trillion dollar annual deficit without tax increases is a subject of contentious debate. But I think an equally important question is whether it is politically feasible to try and close the deficit without tax increases. The perception of social injustice is already an issue that resonates with many independent voters. Just because main street Americans and the legions of unemployed are not camping with the aimless anarchists of the Occupy movement, it does not mean that their anger over the current state of the economy is not simmering. This anger is diffused somewhat because Democrats control the Presidency and the Senate. However, pushing through plans that cut entitlements without tax increases will stir up resentment that the average Americans is paying a heavy price at the expense of the "rich". Thus, although a spending reduction message plays well to the Republican base, it may alienate the independent voters needed to win elections and pass deficit cutting legislation.

Greece will be racked by another debilitating round of strikes this week. Their already weak economy will  slow even more and their budget deficit will grow even larger. Admittedly, a comparison between Greece and the U.S. is a bit like comparing apples to oranges. As ugly as is the U.S deficit problem, it is still solvable. The Greek debt crisis is likely only solvable via a default on their national debt. Their  economy is in a shambles, corruption is rampant, and there is tremendous nationalistic anger about austerity measures that are being forced upon them by outsiders from other Eurozone nations. However, it may not be totally far fetched to assume that some of the strikes and turmoil in Greece could spread to the U.S. A perception that senior citizens and blue collar workers are being "robbed" of entitlements could spark an ugly reaction. The aimlessness of the Occupy movement is one of its primary weaknesses. However, a deficit reduction plan that significantly reduces entitlements without any tax increases could ignite dramatically larger protests and ramp up property damage and violence.

The following is a summary of the "no new taxes" message. (via Senator Chuck Grassley's website). It offers the appeal of:  1) being easy to understand; and 2) being virtually painless for the 53% of households that pay incomes taxes. However, as you read this "no new taxes" message, ask yourself how this will play out with independent voters and the unemployed. Is it really a winning message?

Fiscal discipline and economic growth need to be the top priorities for deficit and debt reduction. Unchecked government spending will further threaten economic opportunity with higher debt and higher taxes. It’d be one thing if tax increases actually were used to reduce the deficit, but that’s not what happens. Since World War II, every new dollar in tax increases has resulted in Congress’ spending $1.17. Raising taxes has been a license for Congress to spend even more. And, every dollar spent by Congress is a dollar taken out of the economy, and higher taxes leave fewer resources for the private sector to make investments, expand production, and create sustainable jobs.


As I noted in a previous post, "back in the '90's, Canada proved that it is possible to get a huge budget deficit under control. Their solution is instructive. The Canadian ratio of budget cuts to increased taxes was 6 or 7 to 1. The Canadian experience provides support for a position that should be much more palatable to voters than a plan that exclusively targets spending cuts. Further, it has the added merit of actually having worked."


Thus, whether or not the strikes and labor unrest in Greece over budget cuts is applicable to the U.S., it should raise at least a bit of concern among those who support a balanced budget without tax increases. 

Did Ross Perot Prove That American Voters Can Actually Do Budget Deficit Math?

On main street, Wall Street, and the occupy camps alike, it seems that Americans are oblivious to the risks inherent in running up trillion dollar annual deficits. There seems to be an almost child like faith that investors and foreign governments will continue to buy up U.S debt. Time will tell how much longer the U.S. will be able to fund it's burgeoning debt with bonds and notes that only average about a 3% interest rate. Obviously, we can fund today's $14.9 trillion dollar debt. However, as even the Congressional Budget Office noted in a July 2010  brief, the U.S. is not immune to risk of a fiscal crisis caused by Federal debt.

Given the lack of concern from most U.S. voters about the growing debt, it is remarkable to recall that back in June, 1992, Ross Perot led the presidential popularity polls with support from 39% of respondents (versus 31% for Bush and 25% for Clinton). While part of Perot's appeal was his populist anti-establishment message, his core platform was the need for an end to U.S deficit spending. In hindsight, it seems almost hard to believe that one of his campaign infomercials drew 10.5 million viewers for a message that was loaded with economic statistics.

The U.S. debt crisis is far more severe in 2011 than it was in 1992. There should be a lesson for U.S politicians from the popularity gained by Ross Perot. His use of charts to explain the dangers of the growing U.S. debt made the deficit math easy to understand.  And once U.S. voters understood the problem and the fact that Perot stood to address it, he gained widespread support from both conservatives and liberals. Given the incredible missteps of Perot's campaign, including dropping out of the race and then jumping back in, it seems shocking that he still ultimately received 19% of the vote on election day.

Solving the U.S. debt problem is going to be politically painful. Hopefully, the cause of fiscal conservatism will find another advocate that is as effective at garnering support for tough policy choices as Perot. Politicians should keep in mind that Perot proved that being honest with American voters about the debt crisis can be an effective campaign tactic.

Punting On Energy Projects Guarantees Stagflation

Demand for U.S. products from Europe is going to slow down to due the debt crisis. The high price of oil is serving as a drag on the U.,S. economy. The U.S. debt is increasing by $3 billion a day. Given these three headwinds, the job market seems likely to stay bleak. The dotcom boom fueled job creation in the late '90's. The housing boom fueled the job creation in the middle of the last decade. This leads to the question of "where is U.S. job growth going to come from in 2012?"

There is only one obvious area of opportunity to ramp up job creation in the U.S., and that is by unleashing domestic energy related projects. A U.S. drive for energy independence offers the best opportunity for getting hiring and the U.S economy back on track

While delaying a decision on the Keystone XL Pipeline by itself is not fatal to the U.S. economy, the hostility of the current administration to energy projects that are economically viable without subsidies is a huge drag on job creation.

The European debt crisis had led to funds flowing to U.S debt auctions. The rates the U.S. is paying to fund our debt is staying remarkably low. This is keeping the cost of funding the $14.9 trillion debt down to only about 10% of receipts. However, while the interest rates on U.S. issued debt has remained low, demand has been a bit soft at a couple of recent auction. It is only a matter of time before the need to fund the rapidly expanding debt leads buyers to demand better returns. This becomes a vicious cycle, higher rates increases the cost of funding the deficit, which requires ever larger actions, and a cycle of higher rate. Thus, the growing deficit ensures that ultimately interest rates will be higher. This is almost certain to cause inflation and a declining value for the U.S. dollar.

The combination of this soon to be upon us debt fueled inflation and not enough new jobs leaves the U.S. on a path toward of devastating stagflation, with both high unemployment and rising inflation.

The risk of the U.S. becoming as much of an economic basket case as Greece has already become is very real. Thus, the delay of a decision on the Keystone XL Pipeline epitomizes why the current job market is such a disaster and why the economic situation is likely to get worse.