Dear Mr. Secretary:
Since the Committee's previous meeting in late October, credit conditions have remained uncertain and the outlook for the economy has become more negative. Expectations for growth in the first half of 2008 have fallen from 1.7% to 1.1% and two primary dealers now expect a recession as a base case for their economic outlook. Elsewhere the odds of a recession have varied between 30 and 50%. Housing continues to be a significant drag on the economy and, although that has largely been offset by a positive contribution from the improvement in the U.S. trade balance, the secondary risk of a drop in consumer spending, combined with some evidence of a weaker labor market, justify heightened concern about the growth outlook.
Inflation has remained somewhat elevated due to price increases for food and energy. However, the slowing economic growth has had a moderating effect on a variety of other consumer prices, especially for goods and services related to housing. Core consumer price measures are rising in a 2% to 2½% range. Chances favor some improvement in these measures amid tight financial conditions, softer home prices and higher unemployment, but the falling U.S. dollar and elevated commodity costs may keep alive concerns about inflationary pressures.
The steady tightening in financial conditions led the Federal Reserve to lower the Federal funds target by 75 basis points to 3½% earlier this month. Policymakers acknowledged that the more restrictive credit environment had increased the downside risks to the economy. Futures markets anticipate further reductions in the policy rate ahead. Expectations for a lower funds rate have contributed to a steeper yield curve with short- to intermediate-term yields having declined the most. Yields across the U.S. Treasury curve are near the lowest levels in a number of years.
The Federal government's budget deficit narrowed in fiscal year 2007. But the pace of revenue collection has eased and economically sensitive spending has firmed in recent months, suggesting a larger fiscal deficit in 2008. Enactment of an economic stimulus package would widen still further the budgetary shortfall.
The Committee was presented with four charges by the Treasury. After a short conversation, we chose to begin with the second charge where the Committee was asked to address their views on the lead/lag effects of revenues and outlays on Treasury debt issuance in various economic cycles, and the potential issuance patterns Treasury should consider given those trends.
One member prepared a presentation on this topic and began the discussion by citing the cyclical nature of tax receipts, suggesting that over three-quarters of the traditional cyclical deficit swing occurs on the revenue side. The observation was made that the revenue weakness occurs coincident with the economic downturn, and continues for a period of many months into the ensuing recovery.
One member noted that CBO projections (as well as others) tended to fall short of the experienced deficits in economic downturns. This member, as well as other Committee members, suggested that the volatility of budgetary balances during these periods should influence Treasury to begin planning for potentially larger borrowing requirements in the very near future.
This member then went on to suggest that within individual non-withheld receipts there is some risk of significant decline. These are driven by capital gains and irregular sources of income, and have risen markedly over the prior few years, and consequently were at risk of deterioration within an economic slowdown and/or equity market correction.
In addition, corporate profit margins are likely to weaken over the coming months, suggesting a potential tangible fall-off in corporate tax receipts. One member suggested, however, that the data on individual and corporate tax receipts shows modest signs of degradation at this point, but pointed out that the March and April final settlements would be more illustrative.
Hence, with an uncertain set of revenue forecasts, and the implementation of an impending fiscal stimulus package, this member and others cited the need for Treasury to consider utilizing various forms of increased borrowing alternatives.
The Committee followed this discussion by tackling the Treasury's first charge which was to solicit our views on future debt issuance in light of these and other issues.
As discussed earlier, members noted that the fiscal position of the Federal government has already shown significant signs of deterioration. For example, tax receipt growth in the first quarter of the fiscal year was under 5% after posting three solid years of strong double-digit growth. This weakness was most pronounced in non-withheld personal income taxes which actually declined slightly over the period and corporate taxes which increased only marginally. At the same time Federal expenditures, which were artificially subdued during the end of the previous fiscal year due to the government running on a continuing resolution, increased markedly to almost 9% year-on-year. Consequently, the budget deficit has weakened materially and is now expected by many private forecasters to be in a range of $325 billion to $400 billion for fiscal year 2008, depending upon the size and composition of proposed fiscal stimulus packages. This is a sharp increase from the 2007 fiscal deficit of $164 billion.
Several members of the Committee noted that the current financing structure and calendar afforded the Treasury with plenty of flexibility over the near-to-intermediate term. There has already been, for example, an increase in Treasury bill issuance such that the outstanding level of Treasury bills has grown from approximately $800 billion to a little more than $1 trillion. Growth in the Treasury bill market was very much welcomed by the financial markets as uncertainty in the credit markets has significantly increased the demand for safe and liquid securities such as Treasury bills and short-maturity notes.
One member noted that the recently enacted TAF program by the Federal Reserve accounted for approximately $80 billion of the increase in Treasury bills outstanding.
Another member noted that the relatively tepid demand for non-marketable SLGs by the Municipal Market has marginally exacerbated the pressure on issuance of marketable securities. Most members agreed that the recent under-performance of Municipal Bonds suggests that the demand for SLGs would remain tepid over the near future.
The combination of these issues, along with the uncertainty surrounding the size of potential stimulus plans, biased most members toward the recommendation that Treasury prepare for the potential need to expand the size, frequency, and perhaps even the reintroduction of issues to its issuance calendar over the coming quarters.
Most members agreed that the Treasury should at first expand issuance across its maturity spectrum and not rely entirely on the expansion of Treasury bill issuance.
During our discussion of this topic, several Committee members noted the growing difficulties surrounding Treasury's cash management function due to the pending lumpiness of future maturities and the quickly changing revenue and expenditure patterns. It was suggested that the Treasury investigate the potential use of longer-dated cash management bills and/or a buy-back program designed specifically to reduce this problem.
In its third charge to the Committee, the Treasury solicited our views on what steps could be taken to minimize the likelihood or impact of systemic fails in the Treasury repurchase market.
This is, of course, not a new topic for participants in the Treasury and fixed-income markets in general and it is increasingly relevant given the recent decline in the Federal funds rate, which can effectively reduce the cost of fails in the market by short sellers and repo counterparties.
Members discussed many of the potential solutions or mitigating actions such as moral suasion by regulators, encouraging foreign investors to participate in securities lending and other tactics.
It was agreed, however, that the best course of action was to encourage industry groups such as the Treasury Market Practices Group (TMPG) and the Securities Industry and Financial Markets Association (SIFMA) to work independently and/or together to present solutions to mitigate these issues.
In the final section of the charge, the Committee considered the composition of marketable financing for the January-March quarter to refund the approximately $54.6 billion of privately held notes and bonds maturing on February 15, 2008, as well as the composition of marketable financing for the remainder of the quarter, including cash management bills, as well as the composition of marketable financing for the April-June quarter.
To refund $54.6 billion of privately held notes and bonds maturing on February 15, 2008 the Committee recommended a $14 billion 10-year note due February 15, 2018 and a $9 billion of the 30-year bond due February 15, 2038. For the remainder of the quarter, the Committee recommended $25 billion 2-year notes in February and March, a $15 billion 5-year in February and March, and a $10 billion re-opening of the 10-year note in March. The Committee also recommended a $25 billion 31-day cash-management bill maturing March 17, 2008, a $20 billion 14-day cash management bill also maturing March 17, 2008.
For the April-June quarter, the Committee recommended financing as found in the attached table. Relevant figures included three 2-year note issuances monthly, three 5-year note issuances monthly, a 10-year note issuance in April followed by a re-opening in June, a 30-year bond re-opening in May, as well as a 10-year Tips re-opening in May, and a 5-year TIPS opening later that same month.
Keith T. Anderson,