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Dear Mr. Secretary:
Since the Committee's last meeting on July 29 th, the economy has begun to show signs that a more robust recovery is underway. Recent data showed that the economy expanded by 7.2% on an annualized basis in the third quarter, the fastest quarterly pace of expansion since 1984. Additionally, surveys of purchasing managers also suggest that the manufacturing sector, which led the economic decline, is in the throws of what most economists expect is a suitable rebound. Despite these positive developments, the labor market remains relatively weak but stable. The average duration of unemployment remains at nearly 20 weeks but claims for unemployment insurance have fallen recently. Also, payrolls expanded in September for the first time since January and are forecast to expand in October as well. Since our last meeting the actual annual rate of inflation has increased slightly on a year-to-year basis while the rate of core inflation has continued to fall.
Short-maturity yields have risen since our last meeting. Two-year Treasury note yields are up 23 basis points to 1.94% despite having fallen to a yield of 1.45% during the period. Ten-year notes actually rallied slightly during the period, and are five basis points lower at 4.39%. The 2-year/10-year curve flattened by 28 basis points. Equity markets continued to improve since our last meeting. The S&P 500 index has risen roughly 6.5% while the NASDAQ composite index is up over 12% during the inter-meeting period. In the currency markets, the dollar has depreciated over 8% versus the Yen and just over 1% versus the Euro.
Against this economic and financial backdrop, the Committee began consideration of debt management questions included in the quarterly meeting Committee charge. In a new format, Treasury presented a chart package, that will be released as part of the Treasury refunding announcement, as part of the Committee charge
The first question asked for Committee's advice on whether Treasury's current financing calendar provided sufficient flexibility given the current fiscal outlook and if not what recommendations the Committee would make as changes to the calendar and over what time period. Prior to tackling the charge, several members asked for additional clarity around OMB's forecasting approach in order to try to ascertain the likelihood of a large miss between actual deficits and forecasts in the short term. As it related to the charge, one member pointed out an increased seasonality to cash flows caused primarily by the mid-month settlement of 5-year notes. This had increased Treasury's reliance on cash management bills and in effect decreased the effectiveness of the 1-month bill in handling seasonal cash flows. As a solution, several members recommended changing 5-year note issuance from mid-month to the end of the month. Treasury, however, noted current 5-year and Treasury bill issuance afforded them significant flexibility and in the long run, mid-month maturities would help smooth cash balances.
Several members felt that given the likelihood of higher than forecast deficits in the future, rollover risk might be too high using the current Treasury calendar. This might argue for an alternative schedule possibly including more long-dated issuance. Another member noted that if the economy were approaching the turning point, Treasury did not want to be harnessed with significant long-dated issuance just as the fiscal situation improved. In effect, it was easier for Treasury to increase auction cycles in a growing deficit world than to eliminate them as deficits declined. The majority of the Committee members felt that Treasury's current financing calendar provided sufficient flexibility given the current fiscal outlook.
The second question the Committee opined on was in reference to adding an additional TIPS security to the financing calendar. The Committee was asked what criteria should Treasury use in determining the appropriate maturity for a new issue.
Treasury shared with the Committee that over the last eighteen months they had received a great deal of input on the TIPS market from investors, consultants and dealers. They felt this has helped them understand more of the market dynamics currently at work. In general, the Committee felt that this market was still in its infancy and could experience significant growth in the future, so adding a new issue would continue to build on the established curve and add to the overall liquidity of the product. The view that TIPS were a diversifying asset in portfolios of equities and fixed income was common and will continue to be accepted by investors over time. In fact, the view of TIPS as a diversifier was more common than TIPS as an inflation hedge.
Under the current issuance cycle, demand develops around the auction process on one specific maturity point of the curve--10 years. The discussion focused on maturities shorter than this liquidity point and longer than this liquidity point.
The Committee first considered issuance of a new maturity in less than ten years (e.g. three years or five years). Members felt that this could bring some continued interest and demand from foreign investors. Some members thought that this would do little to further develop the existing TIPS yield curve, while allowing for the view that foreign purchases of nominal issuance had driven recent demand for Treasury securities.
A number of Committee members felt that there was genuine interest from a number of investor groups for longer dated maturities. State and local governments, pension funds, insurance companies and mutual funds had all expressed interest in the longer end of the TIPS curve. This was viewed as real structural demand in the market The Committee further discussed potential long maturity possibilities. Some members of the Committee felt the 20-year maturity or the 30-year maturity should be considered. One Committee member suggested that issuance in the 20-year maturity would create a readily hedgeable security due to the outstanding 10-year TIPS securities and the off-the-run 30-year TIPS securities. This would also serve the purpose of further building out the yield curve for TIPS where there is currently an issuance gap. A number of members felt that by issuing in the long end, greater liquidity would be created and a liquidity premium would be established. Members felt that investors had become more comfortable with the product, were demanding more issuance, and would welcome longer-dated maturities. In support of this view, one member referenced a Federal Reserve Bank chart from the prior meeting that illustrated a decrease in dealer positions. This was thought to be indicative of increased demand for the product and a general maturation of the product. There was little support for introducing a 30-year TIPS maturity at this point in time.
The third question in the charge asked for the Committee's views on RP fails, particularly on the May 13 10-year notes, which had persisted at elevated levels, including current market conditions and the effectiveness of both private sector initiatives and regulatory measures in reducing those fails.
Members noted that fails increased capital charges, balance sheet usage and counterparty risk on sell side institutions. In some cases market makers had been forced to divert resources from other businesses to compensate for fails in the RP area generally reducing liquidity provided to those other areas. One member mentioned that while "normal" fails were healthy for the market, long-term, chronic fails were not. Most members agreed that private sector initiatives had reduced fails by about 90% primarily by pooling counterparty information and reducing "round-robin" fails. Most also felt that fail reduction based on these types of private sector initiatives had largely run its course.
Some members felt that from a regulatory perspective, increasing the breadth of large position reporting might provide some relief to the residual fail situation, while others thought the remedy was a tap of the 5/13 issue. The overwhelming majority agreed, however, that given the relative pricing of the 5/13 ten-years to other securities in the sector, market forces probably had not been allowed to run their course in reducing fails and that a longer period of time was required for them to do so. Additionally, members felt that Treasury might compromise the many benefits accruing to the current system by increasing regulation prematurely.
The Committee then addressed the question of the composition of Treasury notes to refund approximately $24.8 billion of privately held notes and bonds maturing on November 15 (including $3.4 billion of the 8-3/4% 11/15/03 - 08 that was called 7/15/03) as well as the composition of Treasury marketable financing for the remainder of the October-December quarter, including cash management bills and for the January-March quarter.
To refund $24.8 billion of privately held notes and bonds maturing on November 15, 2003 , the Committee recommended a $25 billion 3-year note due 11/15/06 , a $17 billion 5-year note due 11/15/08 and a $19 billion 10-year note due 11/15/13 . For the remainder of the quarter, the Committee recommended two $26 billion 2-year notes issued in November and December, a $17 billion 5-year note issued in December, and $14 billion of a re-opened 10-year note issued in December and due 11/15/13 . The Committee also recommended two cash management bills, one a $25 billion 12-day bill issued 12/3/03 and maturing on 12/15/03 and the other a $12 billion 4-day bill issued 12/11/03 and maturing on 12/15/03 . For the January-March 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 $17 billion and two of $19 billion), a $26 billion 3-year note for issuance in February and a $20 billion 10-year note issued in February followed by a $15 billion reopening of that 10-year note in March. The Committee further recommended a $12 billion 10-year TIPS for issuance in January. It was noted that Treasury should allow for potential changes in the TIPS maturity as discussed in the charge.
Timothy W. Jay
Mark B. Werner