One of the big fears is that the S&P downgrade will cause the interest that the U.S. has to pay on its bonds to skyrocket. After all, if there is a chance that you will not get paid back, a bond holder should demand a higher interest rate on the bond to compensate. That is why junk bonds are the same thing as high yield bonds.
So what is the bond market saying about longer-term U.S. treasuries in the wake of S&P’s change in opinion about the credit worthiness of the U.S. government? Apparently it thinks the bonds are safer than they were last Friday. The yield on the 5-year is now at just 1.15%, down from an already very low 1.32% last week before the downgrade and 1.57% last month, well before the debt-ceiling deal.
Looking a bit further out to the key 10-year rate, the one thing mortgage rates are generally based on, we are down to 2.47% from 2.75% last week. And 3.02% last month. The 30-year bond is doing much the same thing — down to 3.80% from 4.08% last week and 4.28% last month.
With markets in turmoil there is a flight to safety trade. The markets seem to think that T-notes are still very safe, regardless of what the S&P has to say. Here is a graph of these three rates since the start of 2008. It is from the St. Louis Fed’s FRED (federal reserve economic data) database, and only goes through the close on August 4th. All three maturities are back down where they were in late 2010, and roughly where they were at the depths of the 2008 financial crisis.
Is this how bond holders would behave if they thought that there was a chance that their principal would not be repaid, or interest payments not made on time? Is this how they would behave if they thought that the government would simply turn on the printing presses and get out of the jam that way? Why would anyone lock up their money for 10 years at less than 2.5% if they thought inflation was about to return to even the levels that prevailed late in the Reagan Administration or the first Bush Administration, let alone the those of the Carter and Ford years?
Indeed there are pundits still able to get airtime who are not even talking about late-1970’s-style inflation, but Weimar or Zimbabwe-type inflation. Those looney tunes were wrong in 2008 and they are wrong today. Let’s just step back for a minute and look at the longer-term path of rates.
By any historical standard, T-note rates, at any place on the curve, are at extremely low levels. Despite that, we have lots of people saying that the deficits are a HUGE problem right now, because they “crowd out” private investment. The only way that they could do so is by raising interest rates. Thus, the deficit is the only problem we should be concerned about — not economic growth, not unemployment. We have to control the deficit by cutting spending, even if we make those problems significantly worse.
Of course, other big problems — ones that might take some money to fix, like our crumbling infrastructure — can’t even be discussed. For some reason, Washington DC has entirely bought into this, on both sides of the aisle. This is just plain nuts.
The spending cuts are a key force in slowing down the economy, and as it slows, tax collections at all levels of government fall. Thus the spending cuts are not going to be very successful even on their own terms. A $1 trillion cut in spending is not going to result in a $1 trillion cut in the deficit. At best we are probably talking about a $500 billion reduction in the deficit from a $1 trillion cut in spending.
Deficit Not a Short-Term Problem
When the economy is at full employment, say with the unemployment rate down under 6% and Capacity Utilization up over 80%, then big government deficits can crowd out private investment. Under current circumstances, the only thing that deficits crowd out is unemployment and idleness.
Over the long term we need to bring down the deficit, because at some point we will be at the point where the deficits will crowd out the private sector, and most of the budget will simply be paying interest on the accumulated debt. The key to doing that is, however, to bring the amount that the country spends on health care (what the country spends, not what the government spends) down to the sort of level the rest of the developed world pays for health care relative to GDP. That is more like 10% of GDP, not the almost 18% paid in the U.S.
If we could do that, we would not have a deficit problem at all. The Affordable Care Act (aka “Obamacare”) made a few modest steps in that direction, but did not go nearly far enough. Simply shifting the cost from the public sector and onto individuals is not going to improve the situation.
We need to stop obsessing about the short-term budget deficits and focus on how to drive economic growth. If we get people back to work, they will have income, and thus pay income taxes. The will also not be collecting unemployment benefits, and will be far less likely to be in the SNAP program (i.e. get food stamps). As a result, the deficit problem would start to take care of itself.
Zacks Investment Research
