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Fiscal Baby Steps Aren't Worth the Angst
Unless today's unseasonably-warm temperatures in the New York area (through some metaphysical conservation-of-energy mechanism) means that Hell is freezing over, we are a long way from resolution on the fiscal cliff discussions.
The Republicans countered President Obama's proposal for a $1.6 trillion tax hike with their own plan that would cut the cumulative deficit (according to static scoring, as all of these proposals are) by $2.2 trillion through a combination of closing special interest loopholes, introducing deduction caps on high earners, increasing the Medicare eligibility age, cutting some discretionary spending, and using chained CPI as the Social Security escalator in order to slow the growth of benefits. After having previously lambasted the Republicans for not offering specifics, the White House today labeled the proposal "nothing new," apparently without irony.
To be fair, the Republicans had called the President's proposal a "la-la land offer." So you can see, we are obviously very close to a deal and a smiling, hand-shaking, giddy signing ceremony in the Rose Garden.
All of this is sheer madness. These hikes and cuts are measured over the projection horizon, so we're arguing about cutting perhaps 20% per year from the current trillion-dollar deficits. Good heavens, it's a good thing we're not trying to do something radical, like balance the budget. The combination of the national debt and the Social Security and Medicare liabilities add up to over $1.1million per taxpayer (Source: www.usdebtclock.org), and the debate is over cutting around $20,000 per taxpayer over the next decade. Don't strain yourselves, fellows.
It's incredible that some of these things are even subject to argument. The Medicare eligibility age will eventually be effectively infinity, because the program is not viable on this planet with health care such as we have come to expect, and since the liability is in real terms (units of healthcare, not of dollars) we can't inflate our way out of it. So gradually moving the eligibility age a whole lot higher is something that we simply will have to do. Why not now?
People who say that cutting the deficit by $2.2 trillion over 7-10 years is hard to do have not actually tried it. It is actually pretty easy to get the budget back to some semblance of balance, as long as you don't have to run for re-election or if you consider the future of the country to be more important than winning another term (and you know, there's even a chance your constituents may reward that bold sacrifice!). All that you have to do is to reverse most of the things we've done to the budget over the last decade and you're close - of course, the interest costs now are a lot higher, and will only climb in the future. But if you put entitlement reform on the table, it gets downright easy...again, if you don't have to run for re-election.
Now, that interest portion of the deficit is somewhat scary. The chart below comes from Bloomberg, and it's one of my favorite Bloomberg functions (DDIS). It shows the debt maturity distribution of U.S. Treasuries, and shows the interest and principal amounts currently scheduled.
It appears as if the interest costs (right column) max out at $196bln in 2013 and then decline, but keep in mind that these numbers ignore the fact that debt will be rolled when it matures. The $196bln is something closer to the baseline expectation, in the event that the Fed keeps interest rates anchored pretty near zero. It may be disturbing to note that the Treasury next year needs to roll $1.26 trillion in maturing securities, in addition to the $1 trillion of new money they need to raise due to the deficit; in 2014 the problem will start to grow even scarier as all of the 5-year issuance from 2009 starts to come due, along with all of the debt that has been rolled in the last couple of years. If you want to point to a come-to-Jesus moment in the bond market, it is likely to be in 2014 when this fact intersects with the expectation of the end of QE. It's one thing to sell $2.26 trillion in Treasury securities if the Fed is committed to buying $1 trillion of them. It's a little harder when they're not, or if they are (as they claim they can) actually trying to sell some Treasuries from their own vaults. Good luck.
That's why I don't think we ought to be arguing over $200bln per year in the fiscal cliff. The problem is already much larger than that.
Now, that presumes that QE actually ends sometime in 2013. Some Fed officials have recently made noises to suggest that there is no reason that QE needs to end any time soon, and that the Fed is "nowhere near" the limit of what it can do. The problem is that 2014 will force a very serious choice on the Fed, because I think inflation is going to continue to rise throughout next year (our point forecast for core inflation is about 2.8% for 2013, but with all the tails to the upside), while I seriously doubt that Unemployment will get below 7%. And, as just noted, the market reality is that without Fed buying, the Treasury is going to have a devil of a time placing its debt in 2014 without higher yields (as an aside, I also suspect all dollar swap spreads will be negative in the next few years).
I'm not the only one who thinks that inflation is likely to be rising. While the nominal interest rate debacle is, in my opinion, not likely to hit us until 2014, rising inflation is happening today and the expectation of a continuation of that trend is being reflected in inflation swap rates. The chart below (Source: Bloomberg) shows that 10-year inflation swap rates are again up around 2.75%.
Now, if inflation expectations are rising but the Fed is going to fix nominal 10-year rates at 1.60%-1.80% where they are now, then the scary result is that TIPS yields, already ridiculously low, could go further. I am not bullish on TIPS, because as a rule I won't buy something that is rich on the expectation that it might get richer. That way lies madness, since when the thing you bought goes down you have no plausible excuse. Moreover, speaking for myself, I know that I would be unable to maintain a position that I knew to be fundamentally mispriced the wrong way. But if 10-year inflation expectations went to, say, 3.6% and 10-year nominal yields were fixed at 1.6%, real yields would be forced to -2.00%. This is the reason I won't short TIPS in the current environment, although I view them as overvalued.
What article would be complete without news from Europe? Today Greece offered to pay up to €10bln to buy back their own bonds, with bids due Friday. Completion of this buyback is a precondition to Greece's receiving the next tranche of the bailout, but it will be challenging if they refuse to pay market prices (as the Euro finance minister communiqué released last week suggested, since it limited the prices paid to those prevailing on November 23rd). It still is a philosophical step forward, since at least it serves to recognize the unrealized gains that Greece effectively has when its liabilities are priced where they are now. This is, after all, essentially the same thing that happens in a default: in that case, Greece would offer to pay 35 cents on the dollar for all of its debt. In this case, they're trying to "default" on just enough of the private debt so that the public debt can be carried at par for a while and maybe, someday, be paid off at par.
I just wonder if they can make it to "someday."