Long-term Rates Can’t Rise Too Much — If they Did, the US Government Would Go Broke
The yield on the U.S. Treasury 10-year note, as of this writing, is 65 basis points. This means that, for every $10,000 worth of 10-year notes purchased at recent prices, you get $65 in annual interest payments.
That is an incredibly low yield, not far from the all-time low for interest rates — with “all time” covering 5,000 years of financial history. (There is interest rate data for ancient Mesopotamia circa 3,000 BC.)
That 65 basis-point yield is also low compared to just a few years ago. In 2018, the U.S. 10-year yield was above 3%.
Some investors and money managers are waiting for interest rates to rise again. The bold among them are even shorting U.S. Treasurys (because Treasury prices fall when interest rates rise).
But here is the thing: Long-term interest rate yields can’t rise too much. Or rather, they simply can’t be allowed to rise too much. If they do, the U.S. government will go broke.
The U.S. government, in certain ways like any other business, has to balance income and expenses. The income is mostly from tax collection. The expenses are various items in the budget, plus ongoing payments for entitlement programs and net interest expense on the debt.
Net interest expense can also be thought of as debt service cost. It tallies the total amount of interest, paid out by the government, to holders of government debt.
When interest rates rise, debt service costs go up. And so, as interest rates rise, Uncle Sam has to offer larger coupon payments in order to keep on borrowing. — if it wants the public to keep playing.
Debt service cost is a hefty line item. For the 2019 fiscal year, the Congressional Budget Office (CBO) estimated that the federal debt service cost was $375 billion.
Even for the U.S. government, $375 billion is not couch change. The total defense budget for fiscal year 2019 was about $693 billion.
This means that, for every dollar the government spent on national defense in 2019 — including the purchase of aircraft carriers and missiles, the feeding and housing of troops, and the like — it spent about 54 cents making interest payments.
The CBO also reports that, for fiscal year 2019, U.S. government revenues (primarily via tax collection) were roughly $3.5 trillion. This means that, at $375 billion, interest payments ate up 10.7% of income.
Imagine if your household had to spend nearly 11 cents of every dollar just on interest payments — and that your borrowing habits were getting worse, with the total debt load rising each year. That is the position the U.S. government is in.
In addition to the above, the U.S. government has something called “true interest expense.”
True interest expense considers not only interest payments owed on the debt, but the regular cost of entitlement payouts for programs like Social Security and Medicare.
Government obligations with a fixed ratio of payouts each year are the equivalent of additional borrowing, with payouts functioning like interest rate payments.
As such, if one considers true interest expense, the U.S. government has an outstanding debt level approaching not just $27 trillion, but orders of magnitude more than that. In 2019 the Wall Street research firm AB Bernstein estimated that, if all manner of obligations are factored in, the true U.S. debt load is more than 1,800% of GDP.
Then, too, in 2019 the CBO estimated that net interest rate payments could rise to $928 billion by 2029. Between now and 2029, the cost of interest payments on the debt will eventually be greater than Medicare, child-related spending, and even the annual defense budget.
Making matters worse, the 2019 CBO estimate came well before the pandemic. As a result of the pandemic, the pace of government spending has accelerated far beyond what the CBO expected (or what anyone else expected, for that matter).
The rising cost of interest rate payments on the debt explains why long-term interest rates can’t rise too much. If they do, the U.S. government will find itself bankrupt.
Imagine what would happen if, say, the U.S. Treasury 10-year note suddenly saw its yield spike to 3.25%. At a time when debt loads are rising, the government’s net interest cost would rise roughly five-fold (because 3.25% is five times today’s 0.65% yield).
A spike like that could push the total cost of interest payments into the vicinity of $2 trillion, or even more, in turn representing more than two-thirds of all annual tax receipts.
Imagine then, if you will, a household that devotes not 11 cents out of every dollar to interest payments, but 67 cents. Such a setup is not workable. The household would go bust.
But now we come to the part where the U.S. government proves to be different than any household, because the government owns a printing press.
Because the Federal Reserve can buy bonds at will, and simply add the purchased bonds to its balance sheet, the U.S. government can never go “broke” in the traditional way.
To put it another way: If nobody else wants to purchase U.S. Treasurys, the Fed can step in and buy them, in unlimited quantities if need be, because the payment mechanism is newly created dollars.
In a fiat system, money and debt are the same thing. The central bank simply determines the mix, by deciding to swap bonds for dollars or vice versa.
To keep interest rates low, the Federal Reserve can also do something called “yield curve control.” When a central bank adopts yield curve control as a policy, it buys or sells long-dated Treasurys with the goal of keeping interest rates (yields) below a certain threshold.
And now we come full circle in understanding why long-term interest rates can’t rise too much.
If interest rates did rise too much, the United States government would literally go broke, in the manner of a heavily indebted household spending all of its income on interest rate payments.
The simple way to keep the government from going broke, though, is for the Federal Reserve to buy bonds, in whatever quantity is required, in order to control the yield curve and keep rates low.
To control that yield curve, however, the Fed has to inject newly created dollars into the system, as a means of payment to bondholders when it takes the bonds off their hands.
These dollar injections eventually become extreme, with respect to inflating the supply of money far beyond organic levels of demand.
And that is exactly how a currency gets debased, on purpose, as a free-spending sovereign government turns its debt obligations into currency via the balance sheet magic of the Federal Reserve.
To sum up, anyone waiting for long-term term interest rates to rise could be waiting a long, long time. The government is too indebted and can’t afford to pay substantially higher amounts on the debt it has already accumulated.
Therefore, the Federal Reserve will step in and keep rates low, through unlimited bond purchases if need be, thus debasing the currency in the process.
The only way out of this mess — other than inflating away the debt load by debasing the currency, which is what the Federal Reserve will do — is by increasing the total income level of the U.S. economy through real and robust economic growth.
As such, if you see real and robust economic growth on the horizon, you should expect interest rates to rise, because real economic expansion will give the government room to start paying off debt (think of it like the country having more income to tax).
If you don’t expect a run of growth that outpaces the growing debt load, however — and we most certainly do not — you should expect interest rates to stay low, and the debt load to stay high, and the currency to keep on getting debased (which is bad news for savers, but excellent news for hard assets and Bitcoin).