Markets are starting to worry about the large and continuing issuance of federal debt.  President Obama's PAYGO proposal notwithstanding they have good reason to be concerned. 

Fed Chairman Bernanke has picked up this baton.  In his recent House testimony he validated the Obama administration forecast that the ratio of US government debt to GDP will rise to about 70% by 2011.  After that the two major forecasts from the US government diverge. 

The Obama administration forecast is the rosier one.  It suggests that the debt-to-GDP ratio will start to decline in 2012.  Nothing new here.  History shows that nearly every administration, Republican or Democrat, had rosy forecasts in the “out years” that ranged beyond the expiration of their term of office. 

A more fearful forecast comes from the Congressional Budget Office (CBO).  They are charged with the task of forecasting from a more neutral political view.  According to CBO, the present trajectory leads only higher over the next ten years.  2019 is the limit of their outlook, since CBO is in the business of rolling, decade-long projections.

Worry about compounding deficits is not new in American history.  We have traveled this path numerous times.  The issue for the country is that the current huge Obama deficits have no size precedent since World War II.  And their trajectory seems likely to be revised higher. 

This US dollar-based Treasury debt explosion happens at the same time other governments of the world are on a similar track.  Within only a few years, BCA Research notes, the interest cost of financing the US federal debt is projected to rise to about 4% of GDP, if interest rates stay at present levels.  But if they rise, the cost of refinancing that debt will rise, and the annual interest bill will approach 5% of GDP.  Similar tracks are forecast for the UK and, to a lesser extent, the euro zone.  Japan is the fourth largest global debt issuer, and it is projected to have a slowly rising annual interest bill.

The fear in markets is real.  Annual interest on the federal budget must be paid before anything else.  Otherwise there is a default.  So the compounding effect of continuous and rising issuance of debt relative to the income of a country has a longer-term deleterious impact.  Using the CBO projections instead of the rosier Obama administration estimates, we see this problem exacerbating quickly. 

Markets see it too, which is why the interest rate on the benchmark 10-year US Treasury note has risen from its nearly 2% low to about 3.9% in only a few months.  Treasury bond investors are nervous. Remember, many of them are foreign governments who are parking their reserves in US dollars and with special US Treasury obligations.  As Treasury interest rates rise, they are watching the market value of their reserves decline.  China has become quite vocal on this issue, and Secretary Geithner’s recent assurances to a Chinese audience were greeted with laughter in Beijing. 

At Cumberland we exited our Treasury positions some months ago.  We have emphasized the deployment of bond monies into higher-grade, tax-free municipals and into certain corporate and taxable municipal bonds.  The new issuance of Build America taxable bonds has offered our clients opportunities and we have seized them.  This process is defined as the “spread side” of the bond market.  It offers the best value (higher yields), while the Treasuries side is overpriced (lower yields). 

While spreads are still attractive, the process is more than half over.  Narrowing spreads mean the tailwind for the bond buyer is dissipating.  Total-return bond management is more exacting now.  Markets are more volatile and new issuance is becoming more complex.  Meanwhile the capital market firms that facilitate this bond issuance are still dysfunctional as a result of the credit crisis. 

It is too soon to shorten duration and go to a full defensive posture.  Bonds in the spread sector are still cheap.  But the time for shortening duration is closer than it was a few months ago.  A lot now depends on the credibility of the US government. 

Sadly the outlook here is mixed at best.  Geithner has lost the respect of many in the global financial arena.  The Federal Reserve is moving to distance itself from the Treasury, because it was appearing to be too politically involved.  Both Bernanke and Kohn have mentioned the need for central bank independence.  In a rare occurrence, Fed Chairman Bernanke openly disagreed with the comment attributed to the German chancellor when she criticized central banks.  Vice Chairman Kohn used his Princeton speech to echo this posture. 

Sadly, this protestation in Fed Speak is also not fully believed by the markets.  Markets look at the Congress. And they see the politicians gearing up for an attack on the central bank and a possible reopening of the Federal Reserve Act after the mid-term congressional elections next year.  They see vacancies continuing on the Board of Governors and they speculate about political influences on the Fed.

For three years now and during this entire financial crisis, the Fed board has been forced to make emergency decisions (like Bear Stearns) that required five affirmative votes.  Since there were and still are two vacancies, the intended super-majority rule has been replaced with a unanimity rule. Thus, each Fed governor has a veto.  And the Fed operates with opacity in these decisions.  We only know about them when there are five affirmative votes and an emergency-action provision is invoked.  We never hear about any disagreement among the five governors.  We have no minutes or records to yield forensic evidence about decisions.  We the public and the markets operate in the dark when it comes to the most critical of the Fed’s decisions.

Markets worry about politics and the central bank.  They should.  Massive new federal borrowing of US dollars is originating in this environment of subtle threat to the independence of the central bank.  That is why US Treasury note and bond yields are higher and why their longer trend is up.