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Warning: Uncle Sam Can't Afford A Strong Economy

By the time the U.S. budget deficit reached $1.4 trillion in fiscal (October) 2009, alarm bells were sounding everywhere. Unless the government could get its fiscal house in order, the future promised years of misery as the U.S. kowtowed to its bondholders in China, Japan and elsewhere.

But this crisis simply never came to pass. Thanks to a range of factors for which both political parties can take some credit, the budget gap has already narrowed sharply. According to the Congressional Budget Office (CBO), the budget deficit will fall even further in fiscal 2014 and 2015.

A Fast-Shrinking Deficit

In another bit of good news, the recent era of very low interest rates has enabled Uncle Sam to keep interest payments in check. Five years ago, the government was paying a roughly 4% interest rate on its debt. That figure has fallen by more than 150 basis points since then.


*CBO estimate

 

The net result of the drop in interest rates: Uncle Sam has saved nearly $200 billion in annual interest expense (in light of the growing total debt since then and assuming interest rates had stayed constant at 2008 levels).

The tougher road ahead
Yet just as many investors have begun to stop thinking about our massive debt (which totals $12 trillion when Social Security liabilities are excluded), a pair of factors may conspire to make this a prominent concern again in 2014, and a real crisis within a few years.

And the blame goes to the resurgent U.S. economy.

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As I noted in another column this week, the U.S. economy enters the new year on firmer footing, with some economists anticipating GDP growth in excess of 3% this year. And that should start to push interest rates on longer-term bonds higher. Interest rates on shorter-term debt, known as short rates, are likely to stay quite low for at least the next 12 to 18 months.

But that creates a real conundrum. If the government tries to keep its borrowing costs as low as possible by issuing short-term bonds and Treasury bills, then it will need to roll over that debt in a few years anyway, at which time even short rates may be notably higher.

If the government aims to avoid that scenario and instead issuer longer-term bonds, then it will already see higher interest rates as 2014 plays out. It's safe to say that the era of federal borrowing costs below 2.5% has come to an end.

Every 1-percentage-point increase in the government's borrowing costs raises interest expenses by $120 billion. And that assumes that the size of our debt will remain constant. But that won't be the case: Even though the deficit is shrinking, total debt is growing, and the CBO ominously warns that the deficit will start to grow at an accelerating pace, thanks to increases in mandatory entitlement spending.

The CBO's conclusion: "The government's net interest costs are projected to more than double relative to the size of the economy over the next 10 years -- from 1.3% of GDP in 2013 to more than 3% by 2023."

To keep that from happening, the government would need to find an additional $2 trillion in cumulative savings over the next decade, according to the CBO, which "would require significant increases in taxes, significant cuts in in federal benefits and services, or both." Sadly, the two major parties appear to have already gone as far as they are willing to bring the deficit down to current levels. Higher taxes or deeper spending cuts won't likely be on the table until after this fall's mid-term elections.

The CBO sums up its recent analysis of the debt situation with a fairly grim conclusion: "How long the nation could sustain the projected growth in federal debt relative to the size of the economy is impossible to predict with any confidence. At some point, investors would begin to doubt the government's willingness or ability to pay U.S. debt obligations, making it more difficult or more expensive for the government to borrow money."

That was a concern expressed a few years ago when the budget deficit reached staggering proportions. Though the size of the deficit has become more manageable, the size of the debt has not. The stock market has learned to ignore this issue, but rising interest rates in 2014 threaten to bring the issue right back to the fore.

Risks to Consider: As an upside risk, the U.S economy may be able to sustain an extended period of GDP growth in excess of 3%, which would help boost tax revenues that can largely offset higher interest expenses.

Action to Take -- How rising interest rates in 2014 impact the perception of this trillion-dollar issue could be a big factor for investors to consider as they make portfolio adjustments. In a worst-case scenario, bond vigilantes could lead to a rapid scare in bond markets, as they did 20 years ago.

That means investors need to avoid becoming too complacent -- and should stress-test their investments to be sure that interest-rate risks are manageable. For example, bond funds that own long-duration bonds could prove vulnerable. And yield-producing investments, such as MLPs (master limited partnerships) and REITs (real estate investment trusts), which underperformed in 2013, could see further selling.

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Article source: http://www.streetauthority.com/node/30435491

Comments

  1. martins anuchamba. says:

    The feds should better get it right because the chinese and the russians are watching,americas woes will make those two very happy .in essence we need a financially strong america in charge i say this based on the fact of historical demise of the british empire it began in a similar fashion .if america is to stay on top it should not depend too much on its enemy and it should strive to take back the worlds industrial complex.I say these because I percieve a dangerouse dynamic in play and future confrontations.

    • Jeff says:

      The fall of the British empire started in the middle of the 1800's when they reached a Smith-Ricardo consensus and passed the corn laws. Read "Free trade doesn't work" for an excellent reference on this. Every country in history bigger than about Delaware became first world by combining the best parts of Capitalism, Socialism, and Mercantilism. The only examples from the last century, South Korea and Japan, show the same tried and true pattern.

  2. Jeff says:

    Whenever we talk about the national debt, we should always keep the big picture in mind. National debt went from 120% of GDP or so in 1945 down to 30% in 1980, and is now back near its WWII highs after trying 30 plus years of Reaganomics.

  3. Vic says:

    Just a humble opinion, but the CBO should have more than a grim conclusion after looking at their debt clock at
    http://www.usdebtclock.org. Taxing everything and everyone to the max isn't a solution. If there were a couple of pennies left over someone would spend that too.

    • Jeff says:

      Look at the 1980's. Most economists believed that growth would come from either taxing less and spending less or from taxing more and spending more, but I doubt any of them would have said that taxing less and continuing to spend more would have slowed the economy. Ronald Reagan and George Bush proved in 1980-1992 (although they would never admit it) that keeping spending constant but taxing less actually hurts the economy just from the distortionary effects of reducing taxation on the wealthy. When economists start actually looking at the numbers to see what really happened we will enter a new period of prosperity.

  4. Rasesh Shukla -India says:

    When figures are confusing, Data is doubtful, and deficit is uncertain, how can we judge anything therefrom? policy makers world wide must be understand and follow one basic rule of finance, that
    " You can twist all policies for short term, You can twist some of policy and outcome thereof, even for some longer period, but you just cant twist All policy for all the times"

  5. DDearborn says:

    Hmmm

    That 2 trillion that is needed to fill the budget gap just happens to coincide with the tax breaks granted the 1% starting back in 2006. Restore the pre Bush era taxes on the 1%. And instead of taking greatly increasing the pain and suffering ofthe poorest 150 Million this merely changes the math on the tax returns of the 3 million or so richest people in America. This should be a no brainer.

    • Dinkar Gangwal says:

      I agree whole heartly with DDearborn.
      But who in the congress has guts to make it happen or even bring it to the table?
      I am not holding my breath!

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