INVESTMENT

Hidden Treasury Risks?

Axel Merk

While Treasuries are said to have no default risk (the Fed can always print money to pay off the debt), hidden risks might be lurking in the unlikely form of economic growth.

Total US government debt has ballooned in recent years, but the interest rate paid by the government on its debt has been on a downward trend. If the US returned to the average interest rate paid in 2001 (6.19%), the annual cost of servicing Treasuries would triple, paying more than Greece as a percentage of the budget. Not only would other government programs be crowded out, the debt service payments might likely be considered unsustainable. Except for the fact that, unlike Greece, the Fed can print its own money, diluting the value of the debt. In doing so, the debt could be nominally paid, although inflation would be substantially higher in such a scenario.

These numbers are no secret. Yet without a gradual yet orderly decline of the US dollar—with the occasional rally to make some investors believe the long-term decline of the greenback may be over—the markets do not appear overly concerned. Why? The average interest rate continues to trend downward, because maturing high-coupon Treasury securities are refinanced with new, lower yielding securities, and Treasury Secretary Geithner has lengthened the average duration of US debt from about 4 years to over 5 years.

For the US government, a longer duration suggests less vulnerability to a rise in interest rates, as it will take longer for a rise in borrowing costs to filter through to the average debt outstanding. The opposite is true for investors: the longer the average duration of a bond or a bond portfolio one holds, the greater the interest risk, i.e. the risk that the bonds fall in value as interest rates rise.

Merk discusses Operation Twist to hide interest risk, QE to increase interest risk, economic growth as the biggest risk, the fiscal cliff and entitlements.

source: 321gold