July 29, 2003
Dear Mr. Secretary:
Since the Committee's last meeting on April 30th, the economy has continued to expand at a modest pace. Upcoming data should show that the economy grew by less than 2.0% on an annualized basis in the second quarter, this after a 1.4% growth rate in the first quarter. Additionally, the labor market remained weak with the average duration of unemployment lengthening to nearly 20 weeks or five months. However, despite these signs of ongoing weakness, there have also been some hopeful economic data: surveys of supply managers have suggested that the manufacturing activity is stabilizing or improving and the June orders data suggested that growth may continue to build.
Disinflation continues to be a major theme in the market. Since our last meeting, the annual rate of inflation has slipped even lower and is now running at just 2.1%, down from 2.4% at the end of last year. With the unemployment rate well above NAIRU and capacity utilization under 75%, further disinflation is likely, a fact that the Federal Reserve recently acknowledged.
The Treasury market has seen an increase in volatility since our last meeting with three-month 10-year annualized swap volatility rising to almost 136 basis points from 110 basis points as a high degree of uncertainty regarding Federal Reserve policy and the inflation outlook weighed on the markets. Two-year yields have risen, up 12 basis points to 1.61% despite having fallen to a yield of 1.08% during the period. Ten-year notes also sold off during the inter-meeting period, rising 46 basis points despite having fallen to as low as 3.11% and the 2-year/10-year curve steepened by 34 basis points.
Equity markets continued to improve since our last meeting. The S&P 500 index has risen roughly 9% while the NASDAQ composite index is up over 18% during the inter-meeting period. Volatility, as measured by the VIX index, a weighted average of implied volatilities on S&P 100 index options, has fallen by roughly 16% since our last meeting.
Market estimate show that sizable budget deficits are likely here for the foreseeable future. Many forecasters now expect budget deficits to total over $3 trillion over the next decade.
Against this economic and financial backdrop, the Committee began consideration of debt management questions included in the quarterly meeting Committee charge.
The first question referred to long-term financing at Treasury and was accompanied by a set of related charts. The question asked whether recent adjustments to the financing schedule provided Treasury with sufficient debt management tools to handle the consequent increases or decreases in debt issuance while facilitating their primary objective of meeting the government's financing needs at the lowest possible cost over time.
The first chart described the Treasurys financing requirements including deficit funding, means of financing and net marketable financing. Of note, Treasury mentioned a smaller actual compensating balance and larger net non-marketable financing due to an increase in SLGS (State and Local Government Securities Issuance).
The next chart depicted financing residuals given the current issuance schedule. This chart showed that the current issuance pattern could handle a broad range of variance within one standard deviation of change and that the bill market could absorb this issuance change.
The next chart looked at bills as a percentage of the Treasury's marketable debt. It highlighted the flexibility of the bill market structure and its ability to absorb financing changes.
The next chart illustrated the maturity profile of outstanding Treasury marketable coupons. It showed that as Treasury has increased its issuance, the amount of debt to roll over has increased. It also showed that the distribution of maturities in each quarter are very similar going forward.
The final chart depicted the average maturity of Treasury's marketable debt and the average maturity of its issuance. The noteworthy observation here was that Treasury has made significant changes to coupon issuance without a large affect on average maturity. That is to say that their redistribution of issuance recently to longer dated securities has little affect on the average maturity of the debt.
There was consensus among the members of the Committee that the current financing schedule was flexible and adequate for the foreseeable future. Members also observed that the bill market had enough capacity to absorb any near-term changes in issuance, and further noted that if more capacity were needed in bills, one-year bill issuance could be considered. One member observed that even if the deficit were to drop dramatically, the current schedule would allow enough time to adjust for this change.
The next topic addressed the occurrence of FOMC announcements on Treasury note auction dates. The accompanying slide illustrated that coincident dates of FOMC announcements and 2-year note auctions increased borrowing costs as measured by the current issue versus the off-the-run curve. Treasury then asked for the Committee to comment on whether they should consider adjusting their note auction schedule to avoid coinciding with FOMC announcement dates.
A number of Committee members observed that the actual number of occurrences where the pricing at auction indicated a discount due to an FOMC statement release was few. While the data suggested investors tended to hold back from participating in auctions around FOMC announcements, the bid-to-cover ratios indicated otherwise. The Committee also observed that the efficiency of the auction process has provided participants with over an hour to offset their risks prior to any FOMC announcement. Finally, one member observed that it was not difficult to move an auction by a day and that it would benefit the Treasury to do so. As Treasury set its calendar one year in advance while the FOMC fixed its meeting schedule two years in advance, the Committee recommended that on the dates where issuance coincides with FOMC meetings, Treasury should adjust their calendar.
The Committee voted whether to recommend to Treasury to adjust auction dates to not coincide with FOMC announcements. The results were seven in favor, six against, one abstention.
Next Treasury presented a number of charts highlighting factors that influence their long-term issuance and asked for the Committee's comments on these charts and on the relevance of the factors.
The first set of slides mentioned Treasury debt management's guiding principles which included low borrowing cost over time through regular and predictable issuance as well as the need for borrowing flexibility in order to manage cash balances. The presentation also included issues not affecting borrowing policy such as current interest rates, the annual budget deficit and short-term fluctuations in demand. Another slide showed various methods Treasury used to implement their debt management policy.
The next slide group described the high cost of longer-term issuance relative to shorter-term issuance in two ways. First, it compared the cost of issuing 10-year securities with one-year bills over the last 50 years and second, it analyzed the 10-30 year spread since 1977. In both cases, the longer duration debt was significantly more costly to Treasury over the relevant time periods than the short-dated issuance.
Treasury currently believes that the lowest cost issuance over time requires a diversified debt portfolio and the next two slides explained the rationalization for a diversified portfolio as well as the characteristics of their current portfolio which made it well diversified. One Committee member commented that since Treasury could not predict the future, it was difficult to know what actually constituted the lowest cost issuance over time. Most agreed, however, that Treasury's job was to try to predict the future primarily by using data from the past and that a diversified debt portfolio would best meet their needs.
Treasury then depicted the outsized cost of long-term issuance in the portfolio mix and the compromised flexibility caused by normal bond issuance. In effect, long-dated bond issuance represented 3% of all annual issuance from 1980-2001. It also comprised 17% of all debt outstanding. Additionally, that long-dated issuance represented almost one third of Treasury's interest expense over that period and in a declining interest rate environment. Excessive long bond issuance reduced Treasury's borrowing flexibility and ultimately reduced Treasury's ability to be regular, predictable and transparent. Most Committee members agreed with Treasury and felt that too many long-dated securities were issued previously. They also agreed that if Treasury had been doing similar analysis in the 1980's and 1990's to what they were doing today, they might have approached long-dated issuance policy differently.
The remainder of the slides addressed the need for flexibility in Treasury borrowing policy and the difficulty attaining that flexibility using long-dated issuance. Some relevant points were (1) Treasury financing needs were volatile and uncertain; (2) the investor base for long-term debt was ill suited for high frequency auctions; and (3) long-term debt hampered regular and predictable issuance in improving fiscal environments.
The Committee then commented on Treasury's conclusions which were; (1) for Treasury to achieve their stated goals, they should weight issuance towards less costly and more flexible shorter maturities; and (2) long-dated bond issuance was expensive, inflexible and unnecessary for managing risks in the current environment. One Committee member implied that market timing by Treasury might actually lead to low-cost borrowing over time, but the overwhelming majority felt that predictability and transparency probably saved Treasury far more in the long run than being right at timing the market. Another member felt that more long-dated issuance might promote low-cost borrowing over time by allowing asset managers to more easily adjust liabilities thereby promoting liquidity in the long end of the market. Most members, however, did not agree, believing that current analysis just did not support that conclusion.
Several members described current issuance policy as "a localized solution" and that it might not withstand a stress test where debt issuance increased dramatically in the near future. Treasury responded, however, that they operated on a cash rather than on an accrual accounting basis. Thus, they had to use central OMB forecasts plus standard deviations for planning purposes. Additionally, as a rule, they left longer term appropriation issues to Congress.
The Committee then addressed the question of composition of Treasury notes to refund approximately $43.7 billion of privately held notes and bonds maturing on August 15, 2003 (including $1.3 billion of the 8-3/8% 8/15/03-08 that was called on 4/15/03) as well as the composition of Treasury marketable financing for the remainder of the July-September quarter and for the October-December quarter.
Consistent with the scenario from Treasury, to refund $43.7 billion of privately held notes and bonds maturing on August 15, 2003, the Committee recommended a $25 billion 3-year note due August 15, 2006, a $20 billion 5-year note due August 15, 2008, and a $20 billion 10-year note due August 15, 2013. For the remainder of the quarter, the Committee recommended two $24 billion 2-year notes as well as a $20 billion 5-year note issued in September and $16 billion of a re-opened 10-year note issued in September and due August 15, 2013. For the October-December quarter, the Committee recommended financing as contained in the attached table. Relevant features include three $25 billion monthly 2-year notes, three $20 billion monthly 5-year notes, a $25 billion 3-year note for issuance in November and a $20 billion 10-year note issued in November followed by a $16 billion re-opening of that 10-year note in December. The Committee further recommended a $10 billion re-opening of the TIIS due July 15, 2013.
Timothy W. Jay
Mark B. Werner