The Risk of Low Interest Rates

Harvey Sax

12 years ago

This is an article from Briefing that I found interesting. The conclusion is that low low interest rates are very good for investors. That may be true but I think everyone knows there is no free lunch. I’m not sure what the consequences of easy money and the Fed’s QE program are but it sure has helped juice the stock market. If it’s such a good thing, I have to ask a simple question. Why haven’t we been doing this forever? The reality is there is an ugly side to this policy. Some of these ramifications are being felt already. For example, renters find shelter costs are rising. People living on fixed income are being forced into meager returns or risky assets just to survive.

We are currently living in an artificially created environment of low interest rates, primarily driven by actions of the Federal Reserve. In many words, this is uncharted territory for the government’s role in the economy. What happens if the Federal Reserve loses it’s ability to keep interest rates low?

The US Treasury Auctions Debt

The US Treasury does not set interest rates on the debt that it sells.

All US debt is sold at auction, with potential buyers making a bid for the interest rate, or discount, they are willing to accept. The interest rate paid on the debt is the average weighted interest rate of all the buyers who submitted bids, in lowest order, until the debt issue is sold out.

There are some buyers who bid “market rate” which means they will accept the final average weighted interest rate that results from the auction.

The Federal Reserve Buying Program

The Federal Reserve purchases a large enough amount of US Treasury debt issues to have an impact on the average weighted interest rate that results from the auction process.

The Federal Reserve purchases US Treasury debt with regularity.

Large injections of purchasing are generally announced when they occur, as part of a quantitative easing program. These purchases are intended to keep interest rates low, but also to create credit in the economy, with the hope of stimulating growth.

However, the Federal Reserve also purchases debts over time, in order to help keep interest rates low, by bidding low interest rates in US Treasury auctions.

This has the effect of driving those bidders who demand higher interest rates away, as their purchasing “spot” is taken by the Federal Reserve.

This tactic has helped to keep interest rates low for more than five years now.

The Interest Payment On The Debt

The amount of interest paid by the US Treasury on outstanding debt is significant.

Currently, debt payment amounts to a gross interest payment of $359 billion per year (fiscal 2012 total). (Most budgets list only “net interest payments;” this total includes interest paid on debt held by other government agencies, such as the Social Security Trust Fund.)

This is comparable to $454 billion paid in fiscal year 2011. The lower interest rate environment of 2012 saved the US government almost $100 billion in just one year alone.

The average weighted interest rate on outstanding debt at the end of fiscal 2012 was 2.588%.

The average weighted interest rate on outstanding debt at the end of the fiscal 2011 year was 2.866.

What this means is that a drop in the overall average weighted interest rate in fiscal year 2012 of just 0.3% led to a savings of almost $100 billion in total interest payments.

Even more impressive is the fact that the Office of Budget and Management had forecast a gross interest payment of $440 billion for fiscal 2012, meaning the savings in interest rates could be applied to other programs.
It should be noted, of course, that part of the lower interest rates represents a shift in the maturities of outstanding debt, with an increase in shorter term maturities. Some of the savings in this interest payment are a result of this type of portfolio adjustment.

The Risk Of Artificially Low Interest Rates

The fiscal 2012 budget paid out $359 billion in interest, down from $454 billion in the prior year, based on a average weighted interest rate (as of 9/30/2012) of just 2.588%, done from 2.866 in the year prior.

This is a substantial savings from just a modest decrease in interest rates.All of this is good news, of course.

But it begs the cynical question of “what happens when the Federal Reserve loses the ability to substantially control interest rates?

What happens when the US government has to pay substantially more in interest rate payments?

We made some “back-of-envelope” quick calculations just to “scale” the size of this problem.

Doubled Interest Rates

As a quick estimate of the risk impact of higher interest rates, we simply assumed an environment where interest rates doubled. The average weighted interest rate as of April 30, 2013 was 2.464, so we decided to simply make calculations using an interest rate of 5%.

This would still be a relatively low interest rate environment, as the average weighted interest rate on US Treasury debt would be just 5.0%

However, making the additional payments would be significant.

At 5.0%, the fiscal 2012 gross interest payment would have been doubled, to approximately $800 billion in interest payments, an additional $400 billion over fiscal year’s 2012 actual payments.
With a total gross payment of $800 billion, however, the interest rate payments would jump from approximately 10% of total government spending to almost 15%.

In addition, assuming no additional revenues, the increased interest rate payment of $400 billion would add 40% to the projected deficit in 2013. The projected deficit of $1,006 billion would jump to $1,400 billion.

Such a jump would, of course, increase the amount of debt that the government would have to issue, which would be an additional $400 billion – to cover the increased interest payments on outstanding debt.

It is this aspect of increased interest rates that would have the most harmful effect on the US economy: the need to issue additional debt in order to pay interest on existing debt.

Conclusions

It can be argued that simply assuming a overnight doubling of interest rates is unrealistic. To truly gauge the impact of higher interest rates, a calculation scenario where rates rise gradually and shifts in the duration (weighted outstanding time to maturity) occur gradually would have to be built.
The purpose of this “back-of-envelope” calculation is simply to begin to gauge the risk of the low interest rate environment we currently enjoy.The low interest rate environment is viewed by many as “the way out” of our current economic morass.

However, as long as the US runs a deficit, all maturing debt is paid by issuing new debt.

This makes us vulnerable to a rising interest rate environment of being forced into refinancing at higher rates.

As the above calculations show the truly negative impact of a rising rate environment is that new, additional debt would have to added in order to pay the higher interest rates. That new debt would also be at higher rates, driving the average weighted interest rate up faster than the actual rate of interest rates rising.

This is where the real danger of our low interest rate environment lies: as long as we run government spending at a deficit, any rise in interest rates means newly issued debt, simply to pay the increased interest payments.

Because of this, any environment where interest rates begin to rise sharply has to be viewed as very negative for the overall US government spending picture, and the economy.

Here’s to hoping that the low interest rate environment lasts for a long, long time.

Comments may be e-mailed to the author, Robert V. Green, at aheadofthecurve@briefing.com