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August 2, 2005
Dear Mr. Secretary:
Since the Committee's last meeting in May, the economic expansion has continued at a moderate pace as second quarter GDP expanded at an annual rate of 3.4%. Despite high and rising energy costs and continued Fed rate hikes, consumers have buoyed the expansion and manufacturing has revived now that an overhang of auto inventories has been worked down. Housing activity remains brisk, reflecting still accommodative credit conditions. The supportive financial backdrop together with solid income and employment gains points to another year of slightly above trend growth in 2005.
Record high oil prices are a concern for the economy, draining consumer spending power and weighing on business confidence. Energy-sensitive areas, especially the more competitive manufacturing industries, have borne a disproportionate share of this burden. Nonetheless, strength in construction and a wide array of service industries has been more than offsetting. Despite the continued loss of factory jobs, overall payroll employment growth has remained solid with monthly gains averaging nearly 180,000 in the second quarter, while the unemployment rate has dipped from 5.2% in March to a cycle low of 5%. Corporate profits continued to rise in the second quarter. As of Thursday, July 28, 2005, 69% (market capitalization) of the S&P 500 companies had reported earnings and 86% had met or beaten analysts' expectations, while only 14% fell short.
Both headline and core inflation have moderated in recent months, but the cyclical backdrop suggests that risks of modest price pressures still lie ahead, while recent annual revisions bumped core PCE inflation from 1.6% to 1.9% for the past year. Productivity gains are slowing as the recovery matures, and as labor slack erodes unit labor costs have begun to rise. While inflation expectations have held steady, consumer resilience in the face of sharply higher energy costs underscores firms' stepped up pricing power. Moreover, risks here are enhanced in an environment of renewed upward pressures on energy and potentially on import prices in the wake of dollar declines.
Notwithstanding the relative stability of long-term Treasury yields, information of late has tended to reinforce market expectations of continued Fed tightening. Increases in market rates have been concentrated in short- to intermediate-term maturities, resulting in marked further flattening in the yield curve. Forward markets are pricing in a 100% probability that the FOMC will raise rates by 25 basis points at its August meeting and by another half percent to 4% by year-end.
The Federal budget performance on a 12-month rolling basis has been on an improving trend, largely reflecting the cyclical recovery in tax receipts as income growth revives. Both the Congressional Budget Office and the Bush administration have acknowledged this improvement, with current deficit projections approaching historical averages near 2.5% of GDP. Strong tax receipts led the Treasury to pay down debt in Q2 for the first time since 2001.
Against this economic and financial backdrop, Committee members considered Treasury's charge in four parts.
In the first section of the charge, Treasury asked the Committee to comment on its consideration of the reintroduction of the 30-year bond. Treasury presented the Committee with slides and tables which highlighted several desirable outcomes from the reintroduction of bonds, namely, that issuing bonds would stabilize the average maturity of outstanding debt at 57 months, while remaining the smallest issuance tenor in their debt portfolio. Treasury felt that the incremental expense of issuing bonds would be de minimis in light of the flexibility gained with a stabilizing average maturity of debt, mitigation of rollover risk, and the attraction of new investors to their offerings.
A committee member suggested that Treasury should issue one bond per year, an initial auction and a later reopening. Members felt Treasury should consider adjusting auction dates to allow for efficient stripping of bonds. A member encouraged Treasury to clarify whether its consideration of 30-year bond offerings implied similar consideration of even longer term bonds such as recent offerings of 50-year bonds abroad. The member thought the market would benefit from definitive guidance on this point. Other members emphasized the importance of Treasury having the flexibility to maintain 30-year bond issuance prospectively. The Committee concluded its discussion of bond reintroduction noting generally that it would be a favorable development.
In the next section of the charge, Treasury asked for the Committee's preliminary views on the establishment of a backstop securities lending facility and whether the idea warranted further study or not. Treasury expressed concerns that large and persistent fails may raise their cost of borrowing and stated that they hold valuable the liquidity premium they receive in the marketplace. Systemic fails have occurred more frequently as trading volumes have grown in relation to supply. Treasury presented the Committee with a number of slides depicting the frequency and severity of fails and increasing open interest in ten-year futures contracts. Treasury discussed risks and imbalances associated with systemic fails which may lead to higher borrowing costs over time. Citing challenges to the clearing mechanism from the zero interest rate bound, buy-in rule limitations and market customs, Treasury described a possible approach to the alleviation of systemic fails through a backstop lending facility. Treasury envisions a lending facility offering unlimited quantities of specific securities and onerous borrowing rates for fixed term repo financing.
Members offered numerous and varied opinions as to the merits of such a program. Several members stated favorable views of the proposal particularly if enacted in concert with other steps such as enforcement of buy-in rules, industry cooperation, and encouraging futures exchanges to cash settle or re-coupon contracts. Additionally, members noted that the proposed facility could alleviate embedded credit risk between counterparties that increases during protracted fails. Members were generally in agreement that volumes of activity in specific securities tends to decline or become more expensive to transact in periods of chronic fails and as such could raise borrowing costs for Treasury over time.
Members expressed reservations about the implementation of penalty borrowing rates below the zero bound for a number of reasons. Some felt that back office limitations would present obstacles, others felt that negative rates may encourage speculation exacerbating chronic fail situations. Members encouraged Treasury to further study these periods so that they could articulate precisely when they would employ a backstop lending facility. While Committee members generally viewed the proposed facility in a favorable manner, most believed that further analysis is necessary to ensure that cost/benefit analysis is robust and favorable to Treasury, liquidity in Treasury securities is protected and enhanced, undue market interference is avoided and that policy, operational, and regulatory issues are thoroughly addressed.
In the third section of the charge, a Committee member led a discussion on the impact of foreign ownership of U.S. debt securities on the Treasury's cost of borrowing. Specifically, the charge queried as to whether foreign investors, or other forces, were responsible for the limited increases seen in U.S. yields. The member presented charts highlighting the relationship between the trade-weighted dollar index and U.S. 10-year yields and core CPI changes. In addition, numerous slides depicting net portfolio flows, both official and private, and the increased demand for longer-term maturity assets have served to underscore that currency movements and foreign investor buying have created downward pressure on U.S. interest rates. The member went on to describe other factors such as the increase in global savings rates, the decrease in risk premiums, corporate financing gaps, and structural changes in the bond market which also explain current interest rate levels. This member concluded his presentation opining that these other factors at work, while currently significant, will likely wane in the intermediate term with respect to their impact on rates.
In the last section of the charge, the Committee considered the composition of marketable financing for the July-September quarter to refund $18.6 billion of privately held notes and bonds maturing on August 15, 2005, as well as the composition of Treasury marketable financing for the remainder of the July-September quarter and the October-December quarter. To refund $18.6 billion of privately held notes and bonds maturing August 15, 2005, the Committee recommended a $20 billion 3-year note maturing August 15, 2008, a $13 billion 5-year note due August 16, 2010, and a $14 billion 10-year note due August 17, 2015. For the remainder of the quarter, the Committee recommended a $20 billion 2-year note issued in August, a $20 billion 2-year note issued in September, a $13 billion 5-year note issued in September and a $8 billion reopening of the 10-year note in September. The Committee also recommended a $25 billion 14-day cash management bill issued September 1, 2005 and maturing September 15, 2005 and a $15 billion 8-day cash management bill issued September 7, 2005 and maturing on September 15, 2005. For the October-December quarter, the Committee recommended financing as contained in the attached table. Relevant features include three $20 billion 2-year notes, a $20 billion 3-year note, three $13 billion 5-year notes, a $14 billion 10-year note in November followed by a $8 billion reopening of that 10-year note in December. The Committee further recommended a $9 billion reopening of the 10-year TIPS in October as well as a $9 billion reopening of the 5-year TIPS in October.
Ian G. Banwell
Thomas G. Maheras
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