US Treasury Makes A Bet On Low Interest Rates

US Treasury Makes A Bet On Low Interest Rates




Leading up to the Great Recession, adjustable-rate mortgages (ARMs) allowed many borrowers to get in over their heads. Now the U.S. Treasury has decided to take out what amounts to an ARM of its own by introducing floating-rate notes.

As their name indicates, floating-rate notes carry variable interest rates, which are modificated up or down regularly. The interest rates are tied to an index, such as Libor, that provides a reference for interest rate changes. In May of this year, the Treasury postponed its decision on issuing the notes because, among other things, Treasury officials could not agree on which index to use. They nevertheless have not reached consensus on an index or the ultimate maturity of the securities, but their decision to issue the notes nevertheless indicates some important information about the Treasury’s state of mind.

The U.S. government is making a bet that the historically low interest rates on Treasury debt will keep in place for some time. The wisdom for investors in recent years has been “borrow long and lend short” – whether it be refinancing their mortgages at near-record-low interest rates or avoiding investment in long-term fixed-income securities, which can carry a substantial amount of interest rate risk.

The U.S. government is now doing the exact opposite. Treasury officials seem content to finance the government’s long-term obligations with short-term borrowing. Although the average maturity of the U.S. government’s noticeable debt has been getting longer, it remains one of the lowest of any developed country, at just over 5 years. In contrast, the average maturity of the United Kingdom’s noticeable debt is over 14 years.

Instead of taking advantage of historically low interest rates offered by the Federal save and the need for U.S. Treasury debt caused by the European crisis, the American government has taken the most politically expedient path. The government knows that it can borrow at next to nothing by issuing short-term securities. As of Sept. 4, 2012, the government could borrow for a one month period at a rate of 0.10 percent, and up to one year at 0.16 percent. As a comparison, a 10-year Treasury observe carried a rate of 1.59 percent and a 30-year bond had a rate of 2.69 percent.

Most people would jump at the chance to borrow money at less than 3 percent for 30 years. Such a rate is nevertheless below the long-term average for inflation – approximately 3 percent. In real terms, the government is likely to come out ahead by borrowing at such low rates, already in the long term, because inflation will likely outpace the interest cost of the debt. This method the government will pay lenders back with dollars that are less valuable than when they were lent.

However, when you run $1 trillion budget deficits, it is in your best interest to keep your borrowing costs as low as possible, in spite of of inflation. With noticeable federal debt of over $16 trillion, fractions of a percent translate to billions of dollars. Keeping interest rates as low as possible may make it easier for the government in the short term, but it is ultimately shortsighted.

Many have urged the government to issue more 10-year notes and 30-year bonds in order to lock in the current low rates. There have already been calls for the U.S. to issue 50-year or 100-year bonds. In the past, the Treasury doubted that there would be enough need to sustain issuing such long-term debt. However, need for 100-year bonds is freely apparent. already Mexico was able to issue 100-year bonds in 2011 that yielded less than 6 percent, and earlier this year, the University of Pennsylvania issued 100-year bonds with a record low provide. Since then, interest rates in the U.S. have continued to decline.

however based on the most recent data provided by the Treasury, the government has only issued a total of $270 billion in 10-year and 30-year debt in the first seven months of 2012. It takes the Treasury less than a month to issue that amount in short-term bills, which are instruments that mature in six months or less.

As a U.S. citizen, you should ask yourself why the government is not taking advantage of the opportunity produced by this low interest rate ecosystem and why, instead, it decided to issue debt that will raise its borrowing costs if future interest rates increase.

To be fair, given the amount of short-term financing the government uses, its borrowing costs will rise already without the introduction of floating-rate notes. The government must regularly keep up auctions to roll over its debt obligations; at these auctions, rates on government debt adjust to what the market will bear.

One could argue that the floating-rate notes might already aid the government if they reduce the amount of Treasury bills issued. Floating-rate notes could get investors to lock up their money for longer periods of time, which would reduce the number of Treasury auctions. Lowering the number of auctions would in turn reduce the likelihood of a failed auction should the U.S.’ creditworthiness deteriorate, a prospect already an economy as strong as Germany has faced in recent months. The Treasury may be sending a signal, by the decision to issue floating-rate notes, that it is worried about the prospects of such a failed auction.

Now put on your investor hat. You may surprise if these securities are appropriate investments, in spite of of what they average for the government. Despite my reservations about the issuance of the floating-rate notes and the long-term outlook for the country’s debt, I do believe they can offer benefits to investors, given the current interest rate ecosystem. Floating-rate notes provide a hedge against rising interest rates, because their coupons are modificated as rates rise. This reduces the interest rate risk of the securities.

Some investors may find that they prefer the floating-rate notes issued by the U.S. Treasury because such notes will be backed by the U.S. government. However, investors will likely relinquish higher yields for this reduction in risk. For investors looking for a place to invest cash over short time periods, Treasury bills will likely nevertheless be the best bet, because investors will avoid locking their money up for an extended period.

The first addition to the U.S. Treasury’s lineup in over 15 years seems to be a big gamble. Just as many homeowners bet that they could flip their homes before the teaser rates on their ARMs expired, the U.S. government is betting it can ride the wave of low interest rates for a while longer. This approach may serve to paper over the country’s financial situation in the short term, but we have to hope the government does not wipe out and end up underwater like the unlucky homeowners.




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