Dear Mr. Secretary:
Since the Committees last meeting on February 5th, the economic situation has remained weak. Recently released data shows that the economy grew by just 1.6% on an annualized basis in the first quarter, nearly three quarters of a point below expectations. Disturbingly, this below-potential rate of growth was the result of weakness in all the key sectors: consumption, investment and government spending. Additionally, surveys of supply managers have suggested that the manufacturing activity is falling. As a result, facing tepid growth, firms have continued reducing their workforces. In fact, the economy has lost another 465,000 jobs since we last met and consensus expectations are that the government will report another 50,000 jobs lost in April.
While there is still weakness in many areas, there are also many reasons for optimism. Since our last meeting, the hostilities in Iraq have subsided, oil prices have fallen nearly 25%, the dollar has fallen in value and the housing sector has continued to hold up well. Consumer confidence has also begun to improve. Finally, with the Fed funds rate at 40-year lows and additional fiscal stimulus likely, there is a great deal of stimulus either acting, or soon to be acting, on the economy.
With all of the cross currents acting on the economy and continuing geopolitical tensions, as well as concern about the impact of SARS, the Treasury market has rallied modestly since our last meeting. Indeed, the numerous conflicting factors acting on the markets are evident by the fact that both 2-year notes and 10-year note yields have fallen ten basis points after having traded in similar 45 basis point ranges during the quarter.
Interestingly, despite the uncertainties, equity and credit markets have improved dramatically since our last meeting. The S&P 500 index has risen roughly 8.5% while the NASDAQ composite index is up 12.4%. Furthermore, high grade credit spreads have dropped to 134 from 154 on February 5th. Indeed, credit spreads are now at their tightest level since March 2000, the peak of the NASDAQ.
Budget deficit estimate for FY2003 have migrated to between $350 billion and $450 billion, in some cases $50 to $75 billion higher than at the time of our last meeting and almost $150 billion higher than at the start of the fiscal year. Most expect that the budget situation will deteriorate further in FY2004.
Against this economic and financial backdrop, the Committee began consideration of debt management questions included in the Quarterly Meeting Committee Charge.
The first group of questions referred to long-term financing issues at Treasury and were accompanied by a set of charts relating to Treasurys current financing pattern to projected borrowing needs. The questions included
1. whether Treasury should issue 5-year notes monthly or re-open 10-year notes and if so when
2. the value of these charts in providing advice on financing
3. any extensions or modifications to the charts that would be helpful in future meetings.
The charts described first the Treasury Financing requirements including both net marketable issuance and financing considerations such as Deficit Funding, Compensating Balance, Net Non-Marketable Financing, and Change in Cash Balance. The second chart included illustrative base case issuance scenarios for the February and May quarters for coupon securities and TIIS. The third slide tied together the first two by showing a maturity profile over the next ten years with well dispersed maturities by quarter. In effect, the base case issuance scenario provided a desirable maturity profile from Treasurys perspective.
The next two slides looked at various measures of rollover risk under different issuance scenarios. In all cases rollover risk was either at or near historical highs and average and constant maturities at or near historical lows.
The next slide tackled financing residuals given current issuance under different budget outcomes. Treasury felt and most members agreed that with the various potential budget outcomes, Treasury needed to adopt the most flexible borrowing schedule possible allowing them to both increase and decrease issuance quickly with minimal disruptions to the market.
The next slides mentioned an alternative quarterly issuance schedule to what had been previously announced and featured monthly 5-year notes and reopened 10-year notes as well as a reduction in monthly two-year supply.
The final slide illustrated the flexibility of the alternative coupon issuance schedule. By charting bills as a percentage of marketable debt and deficit as a percentage of GDP. It showed that under almost any reasonable deficit outcome, bills as a percentage of GDP remained well within historical ranges.
While several Committee members mentioned that Treasury should analyze the new schedule from a constant maturity perspective before adopting it, most Committee members felt that the logical progression of the chart show pointed to the need for a flexible borrowing schedule which included monthly 5-year notes, reopened quarterly 10-year notes, and slightly smaller 2-year issuance as well as previously announced cycle changes.
The Committee then turned to discussion of the optimal timeline for moving to the new, more flexible borrowing schedule. Some members felt that the best glide path was for Treasury to announce monthly 5-year notes immediately but wait until a later date, probably the August refunding to indicate its intentions to move to reopened 10-year notes. The majority felt, however, that given the prospects for the budget deficit, Treasury should announce to the market its intention to move to the new borrowing schedule in its entirety. This would increase transparency by giving the market as complete a picture as possible of Treasurys borrowing intentions over the intermediate term. Several members noted that an announcement like this would cause minimal disruption as most market participants had largely factored in the new supply already.
The Committee then turned to the questions and presentation pertaining to Treasury Inflation Indexed Securities.
The Treasury showed the Committee three slides that addressed the Treasurys TIIS program. The first slide illustrated primary dealer trading volumes of nominal and TIIS notes and bonds. Of interest in this slide was the improved performances of TIIS after Treasury reaffirmed their commitment to the program. The second slide showed turnover ratios (primary dealer trading volume divided by outstandings) for nominal and TIIS securities. It showed increased turnover ratios for both products. The third and final slide illustrated primary dealer TIIS positions as a percentage of outstanding TIIS. It showed a steadily declining percentage of held positions by dealers relative to the outstanding issuance of TIIS.
Before discussing what other factors Treasury should use as gauges of demand for inflation indexed securities, the Committee first commented on whether Treasury should use two new auctions and two reopenings to accomplish their annual TIIS issuance or one new issue with three reopenings. Some members felt that fewer issues prevented investor confusion. Most, however, felt that for a number of reasons the market would accept more readily single reopenings over multiple reopenings. First, as securities moved away from issuance date and presumably par, the deflation option inherent in TIIS would become less valuable possibly leading to less demand for multiple reopenings. Second, and most importantly, most members believed that more new issues over a certain period of time rather than just more auctions would lead to greater liquidity in the underlying security. Thus, two new issues together with two reopenings would ultimately create more liquidity than the other structure.
The Committee then addressed the question of what factors other than what Treasury had already illustrated in their slide show should be used as gauges of demand for TIIS. Most members felt that in no specific order of importance Treasury could use the following factors:
1. TIIS auction statistics
2. Dealer positions in securities one year or two years after issuance date
3. Mutual fund data on holdings of TIIS
4. Customer volume in TIIS as a percentage of dealer volume.
At one point one Committee member mentioned that investor demand for TIIS in the 30-year maturity had grown recently. These investors felt that the longer maturity of a 30-year inflation protected security fit well into their asset mix. While this was not a majority view, there was some recognition of Committee members of the point. In general Committee members were encouraged by the continued growth and demand for TIIS.
The Committee then addressed the question of the composition of Treasury notes to refund $2.3 billion of privately held bonds maturing May 15, 2003 as well as the composition of Treasury marketable financing for the remainder of the April-June quarter and for July-September quarter.
Consistent with illustrative base case scenario from Treasury, to refund $2.3 billion of privately held bonds maturing May 15, 2003, the Committee recommended a $20 billion 3-year note due May 15, 2006, a $20 billion 5-year note due May 15, 2008, and an $18 billion 10-year note due May 15, 2013. For the remainder of the quarter, the Committee recommended two $27 billion 2-year notes as well as $14 billion of a reopened 5-year note due May 15, 2008. For the July-September quarter, the Committee recommended financing as contained in the attached table. Relevant features include three $25 billion monthly 2-year notes, three $18 billion monthly 5-year notes, and a $20 billion monthly 10-year note issued in August followed by a $15 billion reopening of that 10-year note in September. The Committee further recommended a $9 billion TIIS due July 15, 2013
Timothy W. Jay
Mark B. Werner