Rising Rates – The Good, The Bad and The Ugly…

Investors sitting on cash over the last several years finally have something to cheer about. Interest bearing deposits have inched up steadily over the last year with many today yielding over 2.0%. Unfortunately, these higher rates are not good news if you are the U.S. government, one of the biggest borrowers around. U.S. debt now totals $15.7 trillion. At 78% of GDP, today’s debt burden is at the highest level since the end of WWII.

Economists alarmed by our growing indebtedness are often criticized for instilling a false sense of panic. Debt levels have, after all, been rising for years. But there are at least three reasons why investors should pay more attention to this issue now.

Debt Levels Are Increasing at a Faster Rate: The Congressional Budget Office (CBO) estimates that in 10 years our outstanding debt will grow to $28.7 trillion or 96% of GDP. This could be a fairly conservative estimate as it excludes additional spending related to infrastructure needs or fiscal stimulus if the economy hits a speed bump. It also assumes that the most recent tax cuts are not extended. If these somewhat optimistic assumptions hold, federal debt per taxpayer would grow from $164,100 today to just over $250,000 by 2028.

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Government borrowing is not always a bad thing. But problems develop when the level of debt grows faster than the ability to support it. This is similar to saying you can carry a bigger mortgage as long as you have a bigger income. Unfortunately, for the U.S. this outcome is unlikely. According to the CBO, nominal annual GDP growth over the next decade is likely to clock in at 3%-4% while the combination of rising expenditures and slowing revenues should result in deficits growing closer to 5%.

The Cost of Carrying Debt is Rising: The upward creep in interest rates and sheer level of indebtedness will wreak havoc on the federal budget. Annual interest costs are expected to increase from their current $263 billion to $915 billion by 2028. At this point, the government will be spending more on interest than on all non-defense discretionary spending combined. Easy fixes like trimming back discretionary programs or tweaking benefits will not solve the problem.

Political Will to Act is Lacking: Federal debt levels have increased under both Republican and Democratic administrations. Today, neither party seems interested in tackling the debt problem. Caps placed on federal spending have been removed several times over the last three years, Medicare cost controls have been reversed and with the recent tax cuts, revenue decreased.

Former Treasury Secretary Robert Rubin suggests reducing debt must ultimately involve two things: compromise on Medicare and Medicaid cost growth and higher federal revenues (read taxes). Reaching a consensus, however, will require making painful choices today for benefits some time in the future – not an easy path for any politician.

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Years of low rates, a gradually improving economy and healthy investor demand has led to complacency regarding the nation’s growing debt. But this issue should not be ignored. Foreign investors own 30% of our outstanding debt. They will continue to have an appetite for it as long as long the dollar remains the world’s reserve currency and a safe harbor during periods of heightened risk. But to assume that their appetite is boundless would be foolish. And at some point in the not too distant future our debt will become a political problem as rising interest costs begin to crowd out spending on key government programs.