To view or print the PDF content on this page, download the free Adobe® Acrobat® Reader®.
October 31, 2006
Dear Mr. Secretary:
Since the Committee's previous meeting in August, the economic expansion has remained on the slower track that emerged in the spring. Growth downshifted in the summer quarter to a 1.6% annual rate as an intensifying decline in homebuilding dominated still solid gains in consumer and business outlays. A timely retreat in energy costs and the absence of major financial restraints suggest that growth in coming quarters is likely to pick up moderately barring major spillover from the housing downturn.
Consumer confidence has rebounded on the steep fall in gasoline prices that is providing a hefty one-off boost to real spending power. At the same time, third quarter corporate profits continued to rise at a brisk 14% pace, meeting or exceeding expectations among 85% of reporting S&P companies to date. Along with moderating interest rates, this backdrop is softening the blow from a sharp falloff in residential investment and flattening home prices. Home sales are down 15% from their highs while housing starts have plunged by 20%. The latter could reinforce a slowing in consumer spending as sizable housing-related wealth effects begin to dissipate.
A 7% drop in consumer energy costs has pulled headline inflation down abruptly, but underlying price measures have crept up to ten-year highs. Year-to-year increases in core consumer measures are now in a 2-1/2% to 3% range. Nonetheless, the continuing fall in energy prices should begin to dampen pass-through effects. Also, a less accommodating monetary environment coupled with moderate demand growth suggests competitive pressures on pricing could begin to reassert themselves, especially if long-term inflation expectations remain contained.
Against this backdrop, the tentative declines in yields on U.S. Treasury securities has stalled as market participants await clearer signals on the likely paths for growth and inflation. Earlier concerns about overheating have faded but forward rates reflect only a slight retracement of previous Fed rate hikes in 2007.
The Federal government's fiscal balance continues to improve. Fiscal year 2006's shortfall was a smaller than anticipated $248 billion. Moderate economic growth ahead should support tax receipts but public spending, especially on health care, also remains brisk.
In the first part of the charge, the Treasury solicited the Committee's view on the fiscal outlook over the near to intermediate term and whether the Treasury is well positioned to address its future financing needs.
In introducing this question, the Treasury referred back to its Quarterly Refunding Charts and page 13 in particular. This exhibit illustrated the financing residuals given the current coupon issuance calendar and the resulting size of weekly bill issuance that is derived from the OMB budget forecast and its historical 10-year average absolute forecast error.
The Treasury further noted that more up-to-date budget forecasts by CBO and a survey of Primary Dealers in government securities was for a significant improvement in the budget deficit.
The general consensus of the Committee was that while forecast errors for the budget deficit are large, the resiliency and robustness of the bill market provides the Treasury enough flexibility to maintain its current coupon issuance structure for the near to intermediate term.
One member pointed out that while recent experience has been for very favorable errors in original estimates of the fiscal position, the vast majority of these improvements have been the result of significant increases in tax receipts while the growth of budget outlays have remained relatively stable. This member also noted that the recent slowdown in GDP and weakness in the housing market may result in less robust growth in tax receipts going forward.
Another member pointed out that the demand for longer-dated coupon issues, particularly from non-U.S. investors, continues to grow and that Treasury should seek to maintain the supply of these issues.
Finally, several members pointed out that if it becomes necessary to reduce the issuance of coupon bearing securities from a continued improvement in the budget deficit, that they would favor the elimination of a specific issue or the reopening of an issue versus a pro-rata reduction in the size of all issues. There appeared to be a consensus within the Committee that many coupon issues were already near their minimum size to ensure needed market liquidity in the current environment.
In the second part of the charge, Treasury asked the Committee for its views on the impact of the slowdown in the housing market on the outlook for the U.S. economy and financial markets. The question comes at a time when traditional measures of the health of this sector would suggest that there could be potential repercussions for the Treasury market.
One member pointed out that the U.S. economy was withstanding the downturn better than might be expected. Another member commented on the mitigating effects to the U.S. consumer from the downdraft in energy prices and the rally in equity markets. Others mentioned the continued availability and attractive current pricing of fixed-rate mortgage credit, as well as the strength of the non-residential construction market as counterbalancing factors.
One member cautioned that a more severe price decline in residential housing than is currently anticipated could be disruptive for Treasuries. This disruption would occur in the event of a return to a deflationary environment with the attendant risk embedded in the negative convexity of the mortgage market.
The general view of the Committee held that the housing market adjustment was proceeding faster than expected but that it appears to be correcting toward equilibrium with the recent pickup in sales volumes, the response of homebuilders and an expected reduction of the supply overhang.
In its third charge to the Committee, the Treasury solicited views on a number of seemingly contradictory financial market signals such as the flat-to-inverted Treasury yield curve which typically foreshadows economic weakness while equity markets are hitting new highs, and while credit spreads, volatility and other measures of risk premia remain low. And further, whether a sudden increase in volatility or risk premiums would pose significant risks to the liquidity of financial markets.
The general view of the Committee was that there is a significant degree of financial market liquidity and global surplus of savings that is keeping risk premia low including the yield of longer-term government securities.
It was further pointed out that while the Dow Jones Industrial Average has been making new highs that most stocks remain far from their highest price levels reached earlier in the decade, and in fact, that the pricing of many stocks as measured by their price/earnings ratio or other fundamental measures are very much within the context of historical norms.
A number of members noted that the low level of financing costs in other developed countries combined with a surplus of global savings has led to a significant amount of non- or less-economic buying of securities and a willingness to give up liquidity in the search for yield and potential return. One member also pointed to the increased focus on liability driven investment by pension funds in the UK, Netherlands and the U.S. as another factor in the reduction of risk premium particularly in long-dated government securities.
As for the Treasury's question on whether a sudden increase in volatility or risk premium would pose a significant risk to the liquidity of financial markets, the general consensus was that yes, such an outcome might occur but that the current surfeit of global liquidity has allowed markets to withstand some rather significant events and yet remain relatively stable and well functioning.
In the final section of the charge, the Committee considered the composition of marketable financing for the October-December quarter to refund approximately $57.6 billion of privately held notes maturing on November 15, 2006 as well as the composition of marketable financing for the remainder of the October-December quarter, including cash management bills, as well as the composition of marketable financing for the January-March quarter.
To refund $57.6 billion of privately held notes and bonds maturing on November 15, 2006, the Committee recommended a $20 billion 3-year note due November 15, 2009 and a $13 billion 10-year note due November 15, 2016. For the remainder of the quarter, the Committee recommended a $20 billion 2-year note in November and December, a $14 billion 5-year note in November and December, and an $8 billion reopening of the 10-year note in December. The Committee also recommended a $25 billion 15-day cash management bill issued November 30, 2006 and maturing December 15, 2006 as well as a $12 billion 8-day cash management bill issued December 7, 2006 and maturing December 15, 2006. For the January-March quarter the Committee recommended financing as found in an attached table. Relevant features include three 2-year note issuances monthly, three 5-year note issuances monthly, one 3-year note issuance in February, a 10-year note issuance in February with a reopening in March, a 30-year bond issuance in February, as well as a 10-year TIPS issuance in January and a 20-year TIPS issuance in January.
Thomas G. Maheras
Keith T. Anderson
Table Q4 06
Table Q1 07