Treasury Bonds: Is There a Growing Bubble?

In no particular order you may have asked: What is this bubble economists keep talking about? Why are so many people worried about it? How will it affect me?

First, let's start with a little historical background on interest rates provided by the U.S. Department of Treasury tabled below:

U.S. Dept of Treasury

12/31/2000

12/31/2007

12/31/2012

T-Bills

6.248

3.917

0.127

Notes

6.093

4.392

1.920

Bonds

8.455

7.361

5.275

Debt Avg.

6.665

4.685

2.274

U.S. Debt

5.7 T

9.2 T

16.3 T

For more than three years, economists have been concerned about a bubble in Treasury bonds. As our table indicates, Treasury rates are substantially lower today than they were in 2007, or even 2000, when the U.S. Stock market previously posted record highs. The bubble in this case refers to what are actually 60-year historic lows that the Treasury is currently able to issue debt at.

Remarkably, the United States has managed to effectively finance over $10 trillion in new debt at basically the same annual interest cost as it did back in 2000, the last discal year with a technically balanced budget. (The two major trusts, Social Security and Medicare, had a combined $200 billion-plus surplus in FY 2000 offsetting an actual net non-trust deficit.)

So when you hear economists concerned about the Treasury bubble bursting, what they are referring to is the inevitable devaluation of our debt which will lead to higher effective interest rates. Bonds trade off their face value, normally issued in denominations of $1,000. As such, a Treasury note issued paying 1.92% semi-annually which matures in a year that is resold at $980 will pay the new buyer basically 4.023%. The new owner recovers the entire face value of note at maturity while receiving both interest payments for the year.

Devaluation of current U.S. securities, whether bills, notes, or bonds, could technically effect America's credit rating, although that is highly unlikely due to the strong secondary market for our debt. The more pressing concern is how fast and how high will the cost of debt increase when the bubble bursts?

The current debt market bubbles are largely the result of Federal Reserve Chairman Ben Bernanke's decision to pump huge amounts of money into the banking system. The Fed's policies over the past couple of years have depressed interest rates and pushed up bond prices far more than normal. Only trouble is, the Fed can't keep this up forever. 

There will come a day when the Federal Reserve cannot continue to suppress the interest cost of Treasury debt and market forces will begin to raise that cost toward historic averages. You do not need to be an economist to understand that even a single 1% increase in the total debt portfolio means over $160 billion in additional interest costs.

What makes the potential bubble even more explosive is that the Treasury, like too many homeowners during the housing bubble, went cheap and short instead of long and stable in its borrowing. Instead of attempting to lock in historically low borrowing costs, the Treasury now has issued more in short-term debt — basically 40% — than the country owed in total when President Clinton left office.

Which leads us to the answer to question number three, "How will any of this affect me?" To be brief, you and I get stuck with the bill. For millennials it may appear as impossible. T-bill rates could spike to over 6% as they were in 2000, but even a jump to 2% would add $120 billion to annual debt.

Of course, Washington could actually do something to soften the blow of when the Treasury bubble will burst, but don’t hold your breath. Whether looking at the Senate, House, or President's 10-year budget, all pretend borrowing costs will remain historically low. Nobody in D.C. wants to tell America that when this bubble bursts the balloon payment coming due is not going to leave anyone wanting to celebrate.