Tuesday, February 15, 2011

US Budget: Entitlement Funding Inflection Points

Within a decade there will no longer be additional surplus funds to be used to purchase US bonds which will have to then be sold on the open market. Call it peak SS Trust Funds, although peak trust might be even more apt. Captive Bidding at the auction: How Bond Vigilantism was swamped
A few years ago, I shared my concerns about Social Security and other entitlement program funding (see above and A New Head: Imagine there's no Social Security Fund).  Mine was no voice crying in the wilderness (I'm not that clever), but one of a chorus singing to an audience of deaf policy makers (perhaps my off-key voice was disturbing).  These underfunded entitlement programs, according to those in charge at the time, wouldn't be an issue for 10 or more years.

While it has only been 3 years and 4 months since I shared my concerns, the underfunding, in my view, is likely to become a big issue, not just amongst TV's talking heads, but in trading rooms around the world, this year- we are near to reaching an entitlement funding inflection point- mainly due to the sharp rise and long duration of unemployment, which will have, I believe, a profound effect on the US bond market. 

The inflection point- when the lack of surplus entitlement funds forces the Treasury to fund the entire deficit in the open market- will force bond investors, if they haven't already, to take a fresh look as US Federal finance at the worst time- a look that will include concerns like the following:

The language of the Social Security Trust Fund gives the illusion that it is an investment fund with tradable economic assets that can be held until needed to pay the benefits of future employees. But it is a fund in name only. It holds no real assets. Consequently it does not generate funds to pay future benefits. These so-called trust fund “assets” (essentially US Treasury IOUs) simply reflect the accumulated sum of funds transferred from Social Security over the years to finance other government operations. Former Congressional Budget Office Director June O’Neill

In an earlier post on the topic I argued (facetiously):

If the SS Trust Fund doesn't really exist, the national debt is at least $2T less than the current $9.05T. Under that head, the debt ceiling hasn't been a "real" issue for many years. In the language of my last post, it isn't that a large portion of the Treasury Market is captive, the US National Debt is actually far smaller, by at least $2T, than assumed. If all intergovernmental holdings are essentially fictitious accounting entries, the US Federal Public Sector debt to GDP ratio is actually 37%

While the Trust Fund doesn't exist except as fictitious accounting entries, the liabilities thereof most certainly do (assuming we don't want a replay of recent Egyptian protests here in the US).  Just as entitlement surpluses reduced borrowing requirements and kept US bond yields much lower than they would otherwise have been, entitlement deficits will increase borrowing requirements and, I believe, push US bond yields much higher than they would otherwise be. 

At this key inflection point, instead of subtracting "intragovernmental holdings" (the euphemism for the fictitious trust fund assets, now totaling some $4.6T) from total debt (leaving a 65% debt to GDP ratio), the total debt figure (nearly 100% of GDP) must be used to perform credible analysis, like calculating interest payments.  This may explain the rather curious (to my mind) forecast of entitlement surpluses for many years ahead in the President's Budget.  Once the surpluses become deficits the unfunded liabilities previously hidden by cash accounting methods become active just as an option, which wasn't delta hedged- option lingo for net present accounting- becomes active when its strike price is crossed.  (a wonderful description of the different accounting methods can be found here)

Call it "Fiscal death, Derivatives-style."

Entitlement Funding, Long Term Unemployment and Bond Yields

As noted earlier, the rise and duration of unemployment has brought the "moment of truth" forward by reducing entitlement receipts (unemployment reduces tax receipts) and increasing outlays (formerly employed retirement aged people begin receiving SS).  Fiscal Year-to-date, the off-budget surplus is just $25B, a 50% reduction from the same period last year.  

The baby boomer rush to retirement has not only begun, it has been accelerated by the employment recession.  Moreover, the cap on SS taxes means that an income surge among high earners, which might raise GDP, will do little to raise entitlement receipts.  The only solution to that problem is employment, and lots of it.

That solution, however, carries its own fiscal risks.  Rising employment means rising consumer demand (especially for gas to drive to work again) and thus, in all likelihood, higher inflation.  Higher inflation (the President's Budget forecast assumes inflation remains at or under 2% through 2016) means higher interest charges on the debt stock and increased SS outlays as COLAs rise.  This sunny forecast assumes no disruptions in foreign appetite for US debt.

Interestingly we may have reached a "damned if you do and damned if you don't" point with respect to employment data driven bond market reaction.  If unemployment remains the same or rises, and trust fund deficits need to be financed from general receipts, bond yields should rise due to increased supply.  If unemployment starts to fall as one would expect in a normal recovery, bond yields should rise as inflation pressures increase.

Geez, maybe that's why bond yields have been rising lately?

Full Disclosure: Short US Treasuries