FROM THE OFFICE OF PUBLIC AFFAIRS
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February 3, 2004
Dear Mr. Secretary:
Since the Committee’s last meeting on November 4th, the economy has continued to grow at a robust pace. GDP expanded at a 4% pace in Q4 of 2003 following the 8% pace in Q3 of 2003. Moreover, the latest economic readings point to a continuation of strong growth in the first half of 2004. The ISM manufacturing report for January hit a 20-year high of 63.6. The latest 4-week average of mortgage applications for home purchases hit a record high, pointing to a continued strong housing market. The stronger trend in consumer spending since the fall is set to be further reinforced by unusually large tax refunds over the next few months as a result of the 2003 tax cuts. In contrast to this strength, growth in payrolls has remained slow, averaging 48,000 per month over the past three months. However, both continuing declines in initial claims and the result of business surveys suggest that an upturn in hiring is likely over the next few months. Consensus for this week’s payroll report is expected to show that 160,000 new jobs were added in the month of January.
Commodity prices, including energy prices, have been rising rapidly. These increases have not yet translated into higher core inflation. To the contrary, the latest reading for the core PCE price index slowed to a new low for the cycle at 0.7%. The annual rate of inflation has fallen below 2% to 1.9%.
The Treasury market has been range-bound over the last three months and yields have fallen modestly since our last meeting: 2-year yields have fallen by approximately 10bp to 1.83% despite having risen to 2.10% during the period. The 2-year/10-year curve has flattened 12bp over the same period.
In line with a strong economic and corporate earnings performance, equity markets continue to improve as well: the S&P 500 Index has risen approximately 8%, and the NASDAQ composite has risen approximately 6% over the past three months. Furthermore, a pick up in M&A activity would indicate an improvement in corporate confidence.
Despite continued strong economic growth, the dollar has maintained its downward trend over the past quarter. It has weakened approximately 8% relative to the Euro and approximately 4% relative to the Japanese Yen.
Compared to previous quarters, budget expectations have been relatively stable. While there is some disparity in opinion among private forecasters about the longer-term budget outlook, most expect the budget deficit to be close to official expectations over the next two to three years.
Against this economic and financial backdrop, the members of the Committee began consideration of debt management questions included in the Quarterly Charge. Following their new format, Treasury presented a chart package that will be released as part of the Treasury refunding announcement.
The first section of the package considers the sensitivity of financing needs to economic factors. Treasury discussed at a previous session that they believe their financing is subject to different sensitivity factors—legislative, economic and technical. In their slides they illustrated the uncertainty of their financing needs due to economic variables including GDP, inflation and interest rates. The question asked of the Committee was “does the Treasury financing calendar provide sufficient flexibility?”
The first two charts outlined Treasury’s financial requirements for the first and second quarters of 2004. These projections had already been released to the public.
The following charts considered the economic risk to the fiscal outlook. The charts demonstrate the volatility of expected outcomes to the market. One member of the Committee recommended that Treasury make the sensitivity analysis portion of the package standard in each quarterly release. By so doing, Treasury will be better able to communicate its borrowing needs under a variety of potential outcomes.
The Committee raised questions concerning the composition of Treasury’s forecasting models. While Treasury was comfortable that their models capture a wide number of potential outcomes, the Committee encouraged them to continue to refine these explanatory variables—both short term and long term—and to share them with market participants.
The Committee largely agreed that the risk to the issuance calendar is minimal. During the past year, new 3-year notes, a shift to monthly 5-year notes and the reopening of 10-year notes have all been implemented by Treasury. The Committee felt this evidences a high degree of flexibility to the issuance calendar.
Treasury next asked the Committee’s advice on what criteria to use in assessing the overall composition of its liability structure. Treasury re-emphasized its goals of increasing the amount of TIPS outstanding both nominally and as a percentage of total debt. Treasury also stressed its stated desire to balance short- and long-term debt issuance.
To that point, Treasury provided slides that showed projected issuance amounts of bills and notes well within bounds observed over the past twenty years. Treasury also provided a slide that showed projections of TIPS outstanding both as a percentage of issuance and as a percentage of total debt. Similarly, Treasury included slides focusing on the benefits and characteristics of TIPS suggesting that long-term investors tend to participate in the auction process and that state and local pension plans are investing more in the product. Lastly, Treasury stressed the diversification benefits of TIPS.
Committee members suggested several criteria by which to assess Treasury’s choice of liability composition as they increase TIPS issuance. Some members felt that flexibility and liquidity concerns should predominate. Others felt that the level and direction of nominal rates in Treasury’s decision-making process was also important. Members felt that Treasury would be well served to further study the variability of bill, note and TIPS issuance. Particularly, members felt that increasing the amount of TIPS outstanding could affect Treasury’s cash flow in an appreciable manner without longer-term plans for bill and note issuance. Substitution of TIPS issuance for either note or bill issuance was viewed by most members as a viable strategy given the growing demand profile for the product.
Treasury then asked the Committee to offer its advice as to the scheduling of the November 2004 refunding and offered three potential options. The Committee agreed to consider the options and discuss this charge at the next meeting. The scheduling at the November refunding is complicated by the general election, a meeting of the FOMC and a national holiday.
The Committee then addressed the question of the composition of Treasury notes to refund approximately $11.82 billion of privately held notes and bonds maturing on February 17th as well as the composition of Treasury marketable financing for the remainder of the January-March quarter, including cash management bills and for the April-June quarter. To refund $11.82 billion of privately held notes and bonds maturing February 17, 2004, the Committee recommended a $24 billion 3-year note due 2/15/07, a $16 billion 5-year note due 2/15/09, and a $17 billion 10-year note due 2/15/14. For the remainder of the quarter, the Committee recommended a $26 billion 2-year note issued in February and a $27 billion 2-year note issued in March, a $16 billion 5-year note issued in March, a $13 billion reopening of the 10-year note in March and a $8 billion reopening of the 10-year TIPS in April. The Committee also recommended a $20 billion 11-day cash management bill issued 3/4/04 and maturing 3/15/04. For the April-June quarter, the Committee recommended financing as contained in the attached table. Relevant features include three monthly 2-year notes (one of $27 billion, and two of $28 billion), three monthly 5-year notes (one of $16 billion and two of $18 billion), a $26 billion 3-year note, a $19 billion 10-year note issued in May followed by a $15 reopening of that 10-year note in June. The Committee further recommended a $12 billion 20-year TIPS for issuance in April.
Mark B. Werner