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Welcome to the Currency War, Part 8: US Issues Variable-Rate Debt

It’s easy to understand the attraction of things like adjustable-rate mortgages and teaser-rate credit cards. They give you cheap money up front and a few years of breathing room in which to raise your cash flow to cover the eventual higher payments.

Sometimes this works out for the best. But frequently not. If your cash flow doesn’t rise, a big jump in interest expense can ruin your life, as millions of American homeowners discovered when the mortgage bubble burst in 2007.

But the appeal of variable-rate debt endures. Now, amazingly, it’s the US government’s turn:

U.S. Sees Floating-Rate Note by 1Q 2014, Lower Coupon Sizes

The U.S. Treasury Department said it plans to sell a floating-rate security as early as the fourth quarter this year and signaled it may decide to “gradually” reduce the supply of notes and bonds at auction.

In its quarterly refunding statement today, the Treasury said a final rule on the floating-rate note auction is planned for coming months, with a first sale estimated to occur either in the fourth quarter this year or the first quarter of 2014. The department said it will use the weekly high rate of 13-week Treasury bill auctions as the index for the notes.

With a budget deficit of more than $1 trillion last year, the Treasury needs to expand its base of investors. So-called floaters may appeal to those who are seeking to protect themselves from a possible increase in interest rates or faster inflation stemming from the Federal Reserve’s unprecedented monetary stimulus.

“The floaters are being tailored to its audience and also to make it easier to transition into the product,” George Goncalves, head of interest-rate strategy in New York at primary dealer Nomura Holdings Inc., said in a telephone interview.

New Offering

The floating-rate notes would be the first added U.S. government debt security since the Treasury Inflation-Protected Securities, known as TIPS, were introduced in 1997.

“Indexing to the bill rate is likely a function of a preference at the Treasury and because global investors, like central banks, are more familiar buying Treasury bills and are likely more comfortable with this approach to the floaters,” Goncalves said.

The minutes said that James Clark, deputy assistant secretary for federal finance, told the panel that the Treasury was tentatively considering $10 billion to $15 billion in floaters a month and would solicit more market opinions as the first auction approached.

Some thoughts
Just when you think we can’t get any dumber, along comes the next beginner’s mistake, committed by supposedly the smartest people the world’s most powerful government can attract.

As the article notes, variable-rate bonds offer buyers some protection against rising interest rates. But of course the other side of that coin is that it increases the risk from rising interest rates for the rest of us. Already, the federal debt is mostly short-term paper that has to be rolled over every year or two. So rising interest rates would send the Treasury’s debt service costs through the roof as each new rollover is at a higher rate. Issuing longer-term floating-rate bonds would simply streamline the translation of higher rates into higher interest costs. In that sense, the new strategy is like maxing out teaser-rate credit cards to pay off a mortgage; good for cash flow in year one, very bad thereafter.

This is not an issue while the Fed is buying up $85 billion of Treasuries each month and rebating the resulting interest to the Treasury. It’s when the Fed tries to stop that things get dicey. Because a robustly-growing economy – which is the goal of all this borrowing and spending – naturally leads to higher interest rates. During the good old days of 1960 – 1980, the average rate on government borrowing was about 6%, or more than twice as high as today.

But rising rates would send the interest the government owes to non-Fed bondholders through the roof, increasing the deficit and either crowding out productive spending – which would tend to slow economic growth – or creating an even bigger mountain of debt that will require low interest rates to pay off. A 6% average borrowing cost applied to the $20 trillion that Washington will owe in another few years yields an interest expense of $1.2 trillion – every year forever, much of it going to China, Japan, and Saudi Arabia.

To sum up, floating-rate government bonds are just one more reason that interest rates can never be allowed to rise (and QE can never stop), even if it means sacrificing the value of the dollar, yen and euro. Devaluation is the only way out – for everyone.

8 thoughts on "Welcome to the Currency War, Part 8: US Issues Variable-Rate Debt"

  1. Pingback: The Küle Library
  2. “…the smartest people the world’s most powerful government can attract.”

    Unbeknownst to most there is an exam called the MAT which is similar to the SAT but measures monetaristic rather than scholastic aptitude. A high MAT score is necessary for placement at the highest levels of economic authority.

    Here are a few representative questions from that venerable exam.

    If the unemployment rate remains high, one should:

    a) Reiterate the effectiveness of QE and suggest that it may be increased if current trends continue.
    b) Implore Congress to spend more and stop being so stingy.
    c) Explain that spending over $500,000 per job created thus far is worth it.
    d) All of the above.

    If inflation continues to be below the Fed’s target of 2%, one should:

    a) Continue QE because inflation is benign.
    b) Continue QE to increase inflation.
    c) Continue QE to fight deflation.
    d) All of the above.

    If the unemployment rate begins to rise, one should:

    a) Continue QE because it may not be working.
    b) Continue QE in case robots aren’t replacing employees.
    c) Continue QE because more people may just be saying that they’re looking for work to keep their entitlements.
    d) All of the above.

    Is gold money?

    a) No, I don’t think so.
    b) Not anymore.
    c) It’s not “legal tender”
    d) All of the above.

    Does debt matter?

    a) No.
    b) It depends.
    c) Of course.
    d) All of the above.

    An economy that has imploded because of myriad price distortions, fraud, corruption, and mal-investments should be saved by:

    a) Bailing out the complicit.
    b) Blaming capitalism.
    c) Indenturing future tax payers.
    d) All of the above.

    What best explains how the “wealth effect” is created:

    a) A rising stock market means the economy is improving so individuals feel like they may get a raise soon or have more work to do so they start buying things just in case.
    b) An improving economy means a rising stock market so individuals feel like they’re missing out on investment gains so they buy things to soothe their depression.
    c) As individuals start buying more things, others join in because everyone else starts to join in too.
    d) All of the above.

    “QE”, or Quantitative Easing works because:

    a) The money has to go somewhere.
    b) Investors “front run” the pre-announced strategy.
    c) Imagine Japan had they not been using it for the last 20 years.
    d) All of the above.

    “Financial Repression” is:

    a) A way to discourage investment.
    b) A way to reduce the compensation for risk.
    c) Necessary to avoid another Depression.
    d) All of the above.

    When the honorable Dr. Alan Greenspan speaks, how many double-negatives does he use?

    a) That question is not non-controvertible.
    b) The number of non-singular negatives cannot be ascertained by not not using non-scientific non-numerical methodologies.
    c) By not taking the inverse view of non-contrarian predictors one can not be relatively unsure of anything not inconclusively deduced.
    d) All of the above.

    Why are “capital controls” really not that bad?

    a) It saves the hassles and expenses of moving money “off-shore”.
    b) Money stays “all in the family”, so to speak.
    c) It protects citizens from potentially unscrupulous foreign governments.
    d) All of the above.

    How does QE decrease U3?

    a) By enabling people to stop working.
    b) By discouraging people from looking for work.
    c) By requiring more economists to study this question.
    d) All of the above.

    If central banks create their own money then why do they care about losing money?

    a) Actually, they don’t.
    b) To maintain appearances.
    c) To intimidate and control governments.
    d) All of the above.

    The main lesson learned from the 2008 financial crisis was:

    a) “Bigness” is relative.
    b) “Moral hazard” is bullish.
    c) A trillion dollars is no big deal.
    d) All of the above.

    If a boatload of $100 bills are dumped on the head of a small business owner, you should expect:

    a) New hirings that month.
    b) An increase in GDP due to emergency care at a hospital.
    c) An increase in aggregate labor hours because someone has to pick up all the “Benjamins”.
    d) All of the above.

    Financial asset “bubbles” are:

    a) Apparent only in retrospect.
    b) Not predictable.
    c) Things of the past.
    d) All of the above.

    If you answered a, b or c to any of those questions then you think too clearly to be a in charge of the nation’s monetary policies.

  3. I see little difference between short term bonds, and variable rate bonds, with the possible exception that buyers of short term bonds can hold to maturity to get out, while holders of the variable rate securities will have to sell them if they want to get out. Both the Fed and the Treasury are in a box. I do not see how they can ever get out of it. If this is indeed the case, we shall see an increase in the Fed bond purchases. How much of an increase or how many incremental increases will the currency markets tolerate? Nobody knows, but the financial system seems to become more and more fragile as time goes by.

  4. There is no question that the impetus for offering “floating-rate” US Treasury bonds is to attract more demand for them since just about everyone, including Warren Buffet recently, has declared US/government bonds to be a terrible investment. The fear of rising interest rates, as JR points out, is one of many monetary dilemmas today. Normally, higher rates are a natural accompaniment to economic health and growth but under the present circumstances of high existing debt, higher rates will implode the economy in part because the $16-20 trillion of outstanding Treasury bonds will suffer at least “paper” losses. Current bond holders would then have the unenviable choice between selling at a loss (or at least forfeiting the gains of the last 4 years or so) or holding them to maturity and receiving paltry income and quite possibly principal repayments with significantly less buying power.

    By the way, there is an important distinction that should be understood between higher prevailing (or “spot”) interest rates and the cost of existing Treasury debt. The $16+ trillion in US Treasury bond debt is a weighted-average rate of about 2% (I think), or about $320 billion. If/when rates begin to rise the cost of servicing the existing debt doesn’t change much; only the new debt issued at the higher rates will cost more. This means that it will actually take years for the Treasury to experience significantly higher debt servicing costs in a rising interest rate environment. That doesn’t mean it doesn’t matter, only that the higher costs would not be felt immediately as some pundits seem to imply or even think.

    However, just the opposite is true for existing Treasury bond holders (and really all bond holders). The “paper” or market value of their bonds change (fall) immediately and in sympathy with prevailing interest rates, and that is the real problem here. The sudden devaluation of “assets” and capital is what would implode the economy long before the bankruptcy of the Treasury. Furthermore, to the extent the Fed owns the US Treasury debt the increase in servicing costs would be muted even more.

    It’s the fall in bond values as quickly as rates rise that is the real danger.

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