State and Federal Borrowing Is Crowding Out Everyone Else

As if the credit markets aren’t already under enough pressure, the mass intrusion of state and federal debt will only make matters worse.

At a time when credit availability is at a premium, the federal government has launched its biggest series of Treasury auctions yet while more states are issuing debt in order to support their spending needs.

Consumers and businesses looking to borrow and investors trying to find a way to navigate a marketplace heading toward higher interest rates will find the conditions daunting, experts say.

“Clearly the government is not the 800-pound gorilla—it’s the 8,000-pound gorilla in the credit markets nowadays,” says Mike Larson, analyst at Weiss Research in Jupiter, Fla. “These numbers are just so mind-boggling. Really what’s going on is you have intractable debt and deficit problems in the country that neither side wants to tackle in a meaningful way, so the market is doing it for them.”

Jeff Cox
Senior Writer
CNBC.com

The phenomenon in which public entities push private borrowers out of the market is often referred to as “crowding out.” The result usually is higher borrowing rates and more difficult choices for investors who have to make sure they’re not putting their money in assets that are sensitive to interest rate moves.

While that problem specifically has not hit the market full bore yet, the signs for intense credit pressure are there.

“You are crowding out a lot of other borrowing from the private sector and are at the very least pushing up interest rates,” says Michael Pento, chief economist at Delta Global Advisors. “We have this huge system of artificially low interest rates and that is in the process of reversing.”

Early signs of crowding-out pressure in the credit markets have come from the latest Treasury auctions.

While 2009 saw demand for Treasurys fairly strong, the early signs in 2010 aren’t as good.

Longer-dated securities have faced weak demand so far, and the small auction Monday of 30-year inflation-protected debt that kicks off a record $126 billion debt sale this week followed the trend.

At the same time, banks have been loathe to put money on the streets as long as they can borrow at historically low levels and use Treasurys to protect capital while still seeing considerable yield.

“Instead of making loans, banks are just playing the yield curve,” Larson says. “We have such a tasty-looking spread between short-term and long-term rates, some money that otherwise would go toward lending is rebuilding balance sheets.”

The latest credit market metrics are indeed daunting for the prospects of private lending against the intense competition on the way from the public sector.

Commercial and institutional lending is off a full 20 percent while total loan volume is down by 9 percent, according to the Federal Reserve.

While there are various reasons for that trend—low demand, concerns over foreign debt ramifications on world markets and a general aversion to risk—analysts expect the influx of government debt to exert pressure than the market has seen in years.

Maryland and New York City are leading the way of municipal and state bond issues that are likely to total $2.65 billion this week. That’s a pittance compared to the federal government’s intention to auction off $2.4 trillion this year, but it’s indicative of a budding trend, particularly among East Coast governments.

“The risk premium for lending money goes up at each one of these steps,” says Walter Zimmerman, chief technical analyst at United-ICAP. “There’s too much debt and not enough appetite for debt.”

As for investors, Larson thinks the best strategy is to avoid long-term debt—be it Treasurys, corporate or high-yield bonds.

Investors can use a growing array of exchange-traded funds to short long-dated debt such as the ProShares Ultra Short 20+ Treasury

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Larson cautions that investors shouldn’t be too quick to bet against real estate—a market historically sensitive to rate changes—because of the numerous other dynamics involved such as inventory and price trends.

But he says the markets overall will render a very clear verdict when it comes to dealing with the high supply of debt on the way. The push higher in yields over the past year, then, could be just the beginning.

“The market is doing what you would expect,” Larson says. “It is extracting a higher premium for Treasury to buy and sell bonds.”

• Slideshow: Biggest Holders of US Government Debt