Fear of High Deficits Sending Mortgage Rates Up

April 17, 2010

Just after World War II, due to war spending and rebuilding Europe, our national public debt reached 108.6% of our gross domestic product (GDP), America’s total annual output of goods and services (according to the Office of Management and Budget). It declined steadily to 25% by the 1970’s as the economy boomed, and stood just under 40% in 2008. But the good times appear to be over. By the end of this year 2010 it will be about 67%, and by 2020 it is projected to reach 90%, as reported last month by the Congressional Budget Office,.near the record level reached in 1946, and not far from the level just reached by Greece (115%).

Our deficits have never been a serious problem, but…

For years our annual deficits have been financed by borrowing – by the Treasury’s issuing bonds. And for years a large percentage of bond buyers have been foreign governments attracted by our political stability, now especially China and Japan, which have amassed large quantities of dollars by selling us their goods.

Deficits were never a serious problem in the past because our entrepreneurs with new ideas were encouraged to start businesses that hired new workers and expand. Businesses and working people pay taxes, and economic growth and low unemployment have tended to keep the deficits and total debt manageable.  Continuing economic growth and low unemployment, together with raising the retirement age, might have been sufficient to solve the long-term viability problems of Social Security and Medicare.

Americans in the business world and labor markets tend to be hard-working, self-reliant and optimistic. Why is this so? Several reasons:

* Our can-do attititude dating from colonial times leading to our rapid geographic expansion in the 19th century and the exploitation of our rich natural resources. Our frontier spirit and “manifest destiny” fueled the push to the Pacific coast;
* The expanding horizons of scientific inquiry in the 20th century (landing a man on the moon, among many other outstanding successes in chemistry, physics, biology and medicine);
* A steady flow of immigrants who brought inexpensive labor and new ideas, and assimilated American culture because they wanted the opportunity to work hard and give their families a better life; and
* The recognition — encapsulated in the Declaration of Independence – that equal opportunity is an essential human right (“We hold these truths to be self-evident, that all men are created equal, that they are endowed by their Creator with certain unalienable Rights, that among these are Life, Liberty and the pursuit of Happiness.”)

Collectively, these factors represent or are largely responsible for American exceptionalism — which has made our 234-year-old nation the world’s most dynamic.

What is different now?

There are two problems with today’s high annual deficits: 1) They are higher than ever before and are projected to remain high. As our deficits accumulate, the US Treasury needs to sell more bonds, and foreign governments need a greater incentive to buy and hold them. And 2) at some point, we will have so many bonds outstanding that it may hurt our credit rating because the debt service will require a larger percentage of our annual output. A lower credit rating makes buyers feel less secure and demand higher interest rates to compensate for the higher risk of default. Higher interest rates mean a higher borrowing cost for the US Treasury, slow the economy, and cost us the business investment and new jobs we need to reduce the deficits.

Impact on mortgage rates

How does this impact mortgage rates? On March 25, the US Treasury auctioned off $118 billion in notes, and bidders were not enthusisastic about taking them. They wanted a higher interest rate to induce them to buy. “Treasuries fell, pushing 10-year note yields up the most since December, as lower-than-average demand at $118 billion in note auctions raised concern that investor interest is waning as the deficit climbs to a record.” (Bloomberg.com, March 26, 2010)

While the Fed is holding its discount rate low to stimulate the economy by making demand loans inexpensive, mortgages are not demand loans — they are long-term loans that issuers hedge with bonds. So when interest rates on bonds rise, as they did in late March, mortgage rates rise too, as they did in late March. This adversely impacts home buying.

The demand for higher interest rates by foreign bond buyers has just started, not coincidentally with the passage of the massively expensive health care law, and, with high deficits continuing for the foreseeable future and probably beyond, the growing expense of debt service will -become a serious problem. Printing money to pay debts will compound the problem as bond buyers demand higher bond interest to compensate them for loss of buying power as well as for higher risk.

Growth hurt, unemployment up, and our sovereign credit rating cut

We can expect further upward pressure on interest rates. Higher interest rates on growing debt will inevitably lead to lower economic growth and higher unemployment. Will the US go bankrupt as a result of the growing cost of servicing the national debt? Hopefully not, but there is a risk, and this risk is the reason that Moody’s rating service has warned that the US may lose its AAA bond rating. “The U.S. and the U.K. have moved “substantially” closer to losing their AAA credit ratings as the cost of servicing their debt rose, according to Moody’s Investors Service.” (Bloomberg.com, March 15, 2010) Through the auction results, the bond market is already pointing out the problem.

We can expect further upward pressure on interest rates. Higher interest rates on growing debt will inevitably lead to lower economic growth and higher unemployment. Will the US go bankrupt as a result of the growing cost of servicing the national debt? Hopefully not, but there is a risk, and this risk is the reason that Moody’s rating service has warned that the US may lose its AAA bond rating. “The U.S. and the U.K. have moved “substantially” closer to losing their AAA credit ratings as the cost of servicing their debt rose, according to Moody’s Investors Service.” (Bloomberg.com, March 15, 2010) Through the auction results, the bond market is already pointing out the problem.

It gets worse: Higher taxes

With a limited appetite of bondholders for more US debt, higher debt service will also lead to higher taxes (starting with “tax the rich” and then spreading to the middle class). As taxes rise, fewer entrepreneurs will want to start new businesses and hire new workers – the engine of America’s economic growth. Government revenues will be stunted over the long term, while expenditures will remain high to provide for the existing entitlements and the new healthcare regime, as well as welfare for large numbers of chronically unemployed, and to pay the rising debt service. A typical but ineffective government response would be to attempt to control the problem through increased regulation and broader, higher taxes.

The markets are the most democratic institution we have — everyone can participate. And broad-based markets don’t lie. This scenario, which is already playing out, is not good for our country’s future.

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