US Treasury Makes A Bet On Low Interest Rates

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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 suggests, floating-rate notes carry variable interest rates, which are adjusted up or down periodically. 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 still have not reached consensus on an index or the ultimate maturity of the securities, but their decision to issue the notes still suggests 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 remain 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 outstanding 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 outstanding debt is over 14 years.

Instead of taking advantage of historically low interest rates offered by the Federal Reserve and the demand 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 note 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 still 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, even in the long term, because inflation will likely outpace the interest cost of the debt. This means 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, regardless of inflation. With outstanding 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 even 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 demand to support issuing such long-term debt. However, demand for 100-year bonds is readily apparent. Even 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 yield. Since then, interest rates in the U.S. have continued to decrease.

Yet 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 created by this low interest rate environment 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 even without the introduction of floating-rate notes. The government must constantly hold 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 even 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 even an economy as strong as Germany has faced in recent months. The Treasury may be sending a signal, through 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 wonder if these securities are appropriate investments, regardless of what they mean 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 environment. Floating-rate notes provide a hedge against rising interest rates, because their coupons are adjusted 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 forfeit higher yields for this reduction in risk. For investors looking for a place to invest cash over short time periods, Treasury bills will likely still 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.

Source by ReKeithen Miller

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