This is the Single Biggest Risk for Stocks (and the Economy) in 2013 and Beyond

In the spring of 1993, the U.S. economy was in a funk. Bill Clinton had just become president with hopes of reviving a moribund economy that was growing just 0.7% on a year-over year-basis at that time. Well, the next few quarters showed modest signs of life as the economy started growing at a 2% pace. 

And then, boom. The economy really built a head of steam, rising by an average of 5% in the final quarter of 1993 and the first two quarters of 1994.

The bond market quickly responded, as bond traders began to demand higher rates in an economy that was quickly absorbing any remaining slack. Just look at what happened to yields on the 10-year Treasury bill (T- Bill) as 1994 progressed.

Of course, few are thinking about lofty bond yields these days. Today’s 10-year T-bill yields just 1.7%. That’s the result of a prolonged economic slump that shows no signs of letting up. But what if our long economic malaise is about to end? What if the housing market and other factors start to finally boost the U.S. economy? Indeed, we’re not all that far away from 3% gross domestic product (GDP) growth, which could come as soon as 2013 or 2014, if the stars start to align.

Frankly, increasingly robust growth could spell real trouble. But not for stocks, which would still look reasonably priced, even if interest rates were a few percentage points higher than they are now. And not for Corporate America, which has already locked in much of its long-term debt at ultra-low rates. We’re talking about real trouble for the U.S. government, perhaps one that could trigger a crisis few are talking about.

Borrow now, worry later
In some respects, policy makers have benefited from a remarkable stroke of good luck. Even though the amount of money the U.S. government owes has been rising quickly, interest payments on that debt have barely budged. Let’s take a look at the past eight years’ worth of data.

No matter how you slice it, $360 billion in annual interest expenses is a massive number. But if the government’s borrowing costs were the same amount in 2005, then that figure could balloon to $682 billion. This means the government could work feverishly to slice our national debt in half (which means taxing the economy a cumulative $7 trillion more than it spends), and the current rate of interest payments wouldn’t change — if interest rates returned to 2005 levels.

For a bit of context, the $360 billion the government now spends on interest payments is more than the combined budget of these five key government agencies:

Now, if rates rose and the annual interest payments swelled to $682 billion, then the following federal agencies would see their funding crowded out:

Of course, there’s no plan to simply eliminate these programs. But each one could face serious cutbacks if rising interest rates lead to a hike in interest expenses.

Now you can begin to see why Federal Reserve Chairman Ben Bernanke is doing everything in his power to force rates down. His ostensible goal is to boost economic activity through benefits that would lower corporate and consumer borrowing costs. But his real goal is to help Uncle Sam forestall a major interest-rate crisis.#-ad_banner-#

Yet at the same time, Bernanke and everyone else would like to see the economy get healthier. A rising economy makes the budget math that much easier as government social safety commitments shrink and government tax receipts rise (thanks to expanded economic activity).

But as we saw in 1994, a firmer economy has the unavoidable effect of firmer interest rates. Analysts at Merrill Lynch say we are already seeing a repeat of the 1993-1994 era begin to play out. Back in 1993, investors were snapping up yield plays such as real estate investment Trusts (REITs), emerging-market debt and other income-producing investments. As a result, there was ample excess global liquidity pushing down yields in many asset classes.

Fast forward to 2012 and “investors have poured money into any bond anywhere that offers a coupon,” noted analysts at Merrill Lynch, and they think that “the resemblance between asset price returns in 1993 and 2012 is almost uncanny.”

A closing window
Perhaps the biggest shame of the modern U.S. fiscal era is the government’s decision to keep rolling over its debt in fairly short-term instruments. In an ideal world, all of the government debt that has been issued during the past few years would have been in 20- or even 30-year bonds. That would remove a great deal of interest rate risk that the government faces. Instead, the vast majority of government borrowings have been in one or two-year debt instruments, which means Uncle Sam will be rolling over trillions of dollars in debt from 2013 to 2015 and beyond. That’s no problem if rates stay low, but it will create a fiscal nightmare if that debt gets rolled over at ever-higher rates.

Risks to Consider: As an upside risk, investors have a remarkable ability to shrug off future concerns if the next few quarters look OK, so don’t be surprised to see a cork-popping rally when the “fiscal cliff” agreement is finalized. 

Action to Take –> An increasingly bleak interest rate picture for the U.S. government does not necessarily spell trouble for U.S. stocks. Many companies are in remarkably strong financial shape, and if they are operating in global industries or in economically-insensitive parts of the U.S. economy, then there’s no reason their revenue streams should crumble.

But for any companies that rely on the largesse of the U.S. government — from defense contractors and for-profit educators, to technology providers — a higher level of interest expense will crowd out the funds available for any other programs. States, for example, count on one-third of their revenue base from Washington, and it looks increasingly inevitable that federal funding will be reduced. That could mean higher state and local taxes, or smaller staffed police departments and larger classroom sizes at schools.

This also explains why investors need to pay close attention to the government’s financial picture long after a “fiscal cliff” resolution is made.” Such an agreement would address issues for 2013, and may even forge a path to a balanced budget. But Congress still needs to tackle the actual reduction of the more than $15 trillion in current long-term debt. And the only way for that to happen is for the government to run surpluses, something nobody in Washington can even contemplate right now.