When the Levee Breaks

There's some good news on the economic front. Morgan Stanley says fourth-quarter growth is better than expected, according to Bloomberg News. Business investment is picking up and stockpiles are falling at a slower pace, it seems. The wire service also reported that durable orders are rising and jobless claims are on the wane.

As the New Year arrives, there are plenty of reasons to believe that the financial and economic environment for 2010 will be much better than it was in 2009. Recovery and growth are welcome, but they bring plenty of fresh challenges with them. The greatest risk is in the Treasury markets, which have swelled in size as the government has bailed out banks and businesses. Attention was focused this morning on the Senate's approval of health care reform. But it took another vote that merits attention. It raised the ceiling on the federal debt for the fourth time in 18 months, boosting it $290 billion to $12.39 trillion. Bloomberg puts the debt increase into perspective:

"The federal budget was in surplus at the end of the last decade, and the government began paying down the debt.

Spending increases, including the cost of fighting two wars, and tax cuts pushed the budget into the red. During Republican President George W. Bush's administration, the federal budget went from a surplus of $128 billion in the fiscal year ending September 30, 2001, to a $459 billion deficit in the fiscal ending September 30, 2008, according to the Congressional Budget Office.

The budget office has projected a deficit of almost $1.4 trillion for the current fiscal year, which ends September 30, 2010."

The massive run-up in debt has been facilitated by some of the lowest interest rates in history. Short-term rates have approached zero and for a brief period actually turned negative. The federal government has been funding some of its mounting long-term obligations by buying short-term debt and rolling it over. As short-term rates begin to rise, it will be more and more of a challenge for the government to fund its existing debt, let alone issue new debt.

Does that dilemma sound familiar? It should. The use of short-term debt to fund longer-term obligations was a critical factor in the meltdown of SIVs and the commercial-paper market at the beginning of the financial crisis in 2007. The greatest risk to the financial system is that the Treasury develops a SIV problem of its own. If that happens, the U.S. would be at ever greater risk of losing its "AAA" credit rating, which would force interest rates across the maturity spectrum even higher. Higher rates would create a new drag on the economy, with difficult to calculate but doubtless unpleasant ramifications, including a "double dip" into the realm of recession and budget cutbacks. If you think that sounds unlikely, take a look at the budget problems in California. States and municipalities already show signs of balance-sheet pressure and there's no reason why such problems can't spread to the federal level. Other nations such as Greece are experiencing problems with sovereign debt.

Is such a meltdown in the U.S. likely? No. "But it's possible," says Steve Persky, co-founder of Dalton Investments, a hedge fund in Los Angeles.

Treasury Secretary Tim Geithner and Fed Chairman Ben Bernanke will have their work cut out for them. In the Treasury market, interest rates are starting to rise and prices, which move in the opposite direction, are expected to rise in 2010. Mortgage rates, which are linked to Treasuries, already have moved up. Meanwhile, prices are expected to rise in the corporate credit market, a sign that reducing excess and risk in the private sector has succeeded at the expense of stability in the public sector. Those public-sector risks will be at the top of the watch list for 2010.