Friday, February 12, 2010

The Disappearing Inflation Act ( Japan Redux)

The US is unlikely to experience any funding problems similar to the rumblings from Greece, Portgual, and overseas markets.

The US shares more in common with Japan twenty years ago, versus the current EU. The US has trillions in money market accounts and liquid investments that could be used to buy up Treasuries. Just like Japan funds its deficits internally with domestic savings being recycled at lower-and-lower interest can the US. Provided that economic activity remains anemic, Treasuries may prove the most viable investment alternative for this cash (vs stocks/non-guaranteed money market funds).

For example, lets say the US has $5 Trillion in debt maturing around 48 months (4-years) at an average yield of 5% (equates to $250Bln interest per annum).

If the US runs a trillion dollar deficit for 5 years, outstanding debt will double to $10Trillion. Assuming tax revenues remain flat and assets are not sold, the total interest expense might actually so? Our Treasury could shorten the average maturity date of newly-issued debt.

Here is the math: 2-year treasury bonds yield .8%. So if our government issues $5 Trillion addtional Treasuries at .8%, total interest expense will increase only $40Bln/annum.

Since older, higher-coupon Treasuries are maturing, lets assume the Treasury refinances at least $2 Trillion of existing bonds, reducing the average coupon-rate from 5%--> .8%. This reduces interest expense by $84Bln= ([5%* $2Trln]-[.8%*$2Trln]. So, net-net, our annual interest cost falls by $44Bln ($84bln savings from low-cost, shorter maturities-$40Bln from interest on new debt)

Ultimately, our funded national debt doubles in 5 years from $5 Trillion-->$10 Trillion, but annual interest expense declines from $250Bln--> $204Bln. Since credit-worthiness is partly determined by ability to fund your debt/interest expense, the US might appear to be a better credit risk by embracing such a strategy, even though it would be more indebted . A shady sub-prime lender might suggest that since doubling of national-debt is saving the US so much money, it would present a great cash-out refi opportunity! In fact, the US should increase deficit spending even more!

The strategy outlined above (shorten debt duration, artificially lower-interest rates, closed-loop system funded by internal savings) has carried Japan for the last 15 years, but seems close to exhaustion (they are nearly 200% debt/GDP, vs the US estimated to be 60% pro-forma for current budget). The strategy will eventually fail at some point in time...and will be ugly when it does. Regrettably, any true "deadline" for sound monetary/ prudent fiscal policy in the US is likely more than a decade away. The risk of losing China/Japan as buyers of US Treasuries could easily be offset by aggressive government actions/domestic buying.

In summary, Obama/Congress has free rein to run massive deficits, avoid cutting pensions, perhaps even avoid dealing with Medicare obligations. How do you make money off any of this? not clear, but Japan-style outcome seems the most likely outcome (weak long-term equity markets next ten years, stable/rising treasury bonds).

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