A summary of a WSJ article on U.S. debt here, by Alan Greenspan (18 June 2010):
- Federal debt to the public has surged from $5.5 trillion to $8.6 trillion in the past 18 months. This is a sign of fiscal excess, which typically shows up as inflation and high long-term interest rates, but have not. Federal debt to the public rose to 59% of GDP by mid-June 2010 from 38% in September 2008. To borrow more, the U.S. Government will need to pay much higher interest rates.
- The reason for the surge in Federal debt to the public is because with the collapse of major financial institutions such as Lehman, the public is now taking on more the U.S. Government debt to fill the gap (which originally would have been bought by the failed financial institutions).
- The 10-year swap spread is a proxy for the Treasury’s borrowing capacity. The smaller the spread (or negative), the worst it is for the borrowing capacity. For example, if the spread is negative, it means that the Treasury is paying a higher interest rate on the 10-year Treasury note than the private sector 10-year swap rate
[Note: A private swap rate is the fixed interest rate required of a private bank or corporation to be exchanged for a series of cash flow payments, based on floating interest rates, for a particular length of time. A dollar swap spread is the swap rate less the interest rate on U.S. Treasury debt of the same maturity].
- When there was a budget surplus in 2000, the 10-year swap spread in Aug 2000 was 130 bps. As the deficits mounted, it dropped to 77 bps in Sep 2008, and negative 13 bps in March 2010. Due to the recent Euro crisis, there was a temporary increase in demand for U.S. Treasuries and the 10-year swap spread rose to 12 bps on 14 Jun 2010.
- While low long-term interest rates can persist, the situation can also change suddenly. For example between early October 1979 and late February 1980, the yield on the 10-year note rose almost 4%.
- The post-baby boomer labour force will not be able to consistently increase output per hour by more than 3% annually. Hence the economy cannot grow out of the fiscal pressures.
- Only cuts or rationing of medical care, a significant rise in the eligible age for health and retirement benefits, or significant inflation, can close the deficit. Large tax increases would sap economic growth (and the tax base) and will achieve little added revenues. Persistent borrowing from abroad must be avoided as foreigners may not finance U.S.’s current account deficit indefinitely.
While Greenspan focused on the fact that the Treasury yields went up in March 2010 helping to cause the negative swap spread, he neglected to highlight that the swap spread flipped to negative also because the swap rate went down. A few reasons were given in various articles:
- There was hedging activities due to large corporate bond issuance. To hedge, they swap from paying fixed (for their corporate bonds) to paying floating, hence they sell swaps to receive fixed (to pay their corporate bonds) and pay floating. Selling a swap essentially buys a fixed rate bond and sells a floating rate bond. This increased demand for selling swaps caused the swap rate to go down.
- Traders bought swaps to pay fixed in anticipation that the interest rates will go up once the Fed’s mortgage purchase program ends. When those trades were unwound, traders sold swaps to receive fixed, pushing down the swap rate.
- The mortgage market used to provide fixed rate payments. Now with the mortgage market still not yet recovered, this pushes some players to turn to the swap market to sell swaps to receive fixed.
- Pension funds prefer to receive fixed through swaps rather than Treasuries as they are afraid of yields going up due to oversupply of Treasuries, and it is also easier to get out of a swap then a long bond position.