February 2, 2021
Letter to the Secretary
Dear Madam Secretary:
It is an honor to address this letter to you. Congratulations on your historic and inspiring appointment. We look forward to the Committee’s service to you and the Treasury.
Economic activity rose in the fourth quarter of 2020, with a 4.0% annualized increase in real GDP. The economy has recovered rapidly since the early stages of the pandemic, but has decelerated as the winter virus resurgence weighs on the economy. Since the Committee last met, successful vaccine trial results have provided reason for optimism, though the still-high number of virus cases and the emergence of more infectious virus strains pose downside risks. Going forward, the course of the virus and progress on vaccination will play a large role in determining the trajectory of the economy.
Since the last refunding, the Federal Open Market Committee (FOMC) maintained the target range for the federal funds rate at the effective lower bound of 0%-0.25%. Overall financial conditions have eased on net since the Committee last met. Equity prices rose by roughly 10%, while the trade-weighted dollar has declined by roughly 3% on net since the last refunding. The 2-year Treasury yield edged down slightly while the 10-year Treasury yield rose by roughly 20 basis points.
Consumer spending rose at a 2.5% annualized rate in the fourth quarter, following a 41.0% annualized increase in the third quarter of the year. Services spending increased at a 4.0% annualized rate, while nondurable goods spending declined at a 0.7% rate, and durable goods spending remained flat. The recovery in consumer spending has varied widely by industry, with overall goods spending 7.0% higher than year-ago levels, but services spending still 6.8% below year-ago levels. The slower recovery in services reflects continued weakness in face-to-face sectors such as transportation, recreation, and food services.
Business fixed investment increased at a 13.8% annualized rate in the fourth quarter, and remains 1.3% below year-ago levels. Structures investment increased at a 3% rate following four consecutive quarterly declines, equipment investment rose at a 24.9% rate, and investment in intellectual products increased at a 7.5% rate. The change in inventory investment contributed 1.0 percentage points to GDP growth in the fourth quarter. Regional and national manufacturing surveys have continued to show increased levels of activity through January. The Federal Reserve’s Beige Book also indicated that manufacturing activity continued to recover in almost all Districts, despite increasing reports of supply chain difficulties.
Residential investment rose at a 33.5% annualized rate after surging at a 63.0% rate in the prior quarter, to a level 13.7% above that a year ago. New and existing home sales, housing starts, and building permits have all surpassed their pre-virus levels in recent months. Surveys continue to show very high levels of optimism among home builders, and mortgage rates remain at historically low levels and should continue to support the housing sector.
Net exports subtracted 1.5pp from real GDP growth in the fourth quarter. Real exports increased at a 22.0% annualized rate while real imports increased at a 29.5% annualized rate, following sharp increases in both in the third quarter of the year. Federal spending edged down at a 0.5% annualized rate in the third quarter, while state and local spending declined at a 1.7% rate.
The federal budget deficit was $572 billion in the first quarter of fiscal year 2021, following a $3.1 trillion deficit in fiscal year 2020, based on the Congressional Budget Office’s estimates. The deficits largely reflect fiscal relief measures taken during the recession to support consumer spending and small businesses in the face of large job losses and declines in business revenues. The deficit is set to remain elevated following passage of a COVID relief package worth roughly $950bn as well as ongoing negotiations for further fiscal aid.
The labor market has improved rapidly but stalled in December, with the first decline in nonfarm payrolls since April. Nonfarm payrolls decreased by 140k in December, driven by a 498k drop in the virus-sensitive leisure and hospitality sector. The unemployment rate was unchanged at 6.7% in December, while the broader underemployment rate fell by 0.3pp to 11.7%. The labor force participation was unchanged at 61.5%, and the employment-to-population ratio was also unchanged at 57.4% in December.
Consumer price inflation has remained soft. The total personal consumption expenditures price index increased at a 1.5% annualized rate in the fourth quarter, while the core measure excluding food and energy increased at a 1.4% rate. The core measure rose 1.4% over the last four quarters, well below the Federal Reserve’s 2% target. While the disinflationary pressure from the collapse in demand in virus-sensitive sectors has abated somewhat, these categories continue to account for much of the shortfall in year-over-year inflation.
In addition to keeping the funds rate at the effective lower bound, the FOMC provided new forward guidance for asset purchases at its December meeting. The new guidance states that the FOMC will continue to increase its Treasury holdings by at least $80bn per month and its MBS holdings by at least $40bn per month “until substantial further progress has been made toward the Committee’s maximum employment and price stability goals.” The median projected path for the funds rate in the December Summary of Economic Projections continued to show no change through 2023, although five participants project at least one hike by then.
In light of this financial and economic backdrop, the Committee reviewed Treasury’s February 2021 Quarterly Refunding Presentation to the TBAC. Through Q1 2021 receipts were $803 billion (0.3%) lower than the same period in 2020. Total outlays over the same period were $1,332 billion higher, an increase of 17% relative to the comparable period in 2020, mainly due to payments related to COVID-19 relief efforts. Q1 FY21 outlays were 25.7% of GDP, compared to 21.4% of GDP for Q1 FY20. Based on the Quarterly Borrowing Estimate, Treasury’s Office of Fiscal Projections currently projects a net privately-held marketable borrowing1 need of $274 billion for Q2 FY 2021, with an end-of-March cash balance of $800 billion. For Q3 FY 2021, the net privately-held marketable borrowing need is estimated to be $95 billion, with a cash balance of $500 billion at the end of June. Both of these estimates do not include any assumption for additional legislation that may be passed.
The Committee noted the elevated cash balance that Treasury has maintained in recent months and the updated assumption that it would drop to $500 billion over the period through June. The higher balance has been held to account for the potential need for funds amid considerable uncertainty about the path of fiscal policy and the timing of the associated projected payments. Treasury’s approach has been precautionary given its desire to be able to disburse funds quickly to support the economy without necessitating abrupt shifts in issuance. The assumed decline in the cash balance would be consistent with an outcome in which Treasury used those balances to meet some of its need for funds over that period.
The debt limit suspension period is slated to end on July 31st. Based on past precedent, it is possible that the cash balance may need to reach significantly lower levels by that date. TBAC members agreed that this outcome could be very disruptive to the Treasury market. The TBAC strongly urges Congress to suspend or raise the debt limit in a timely manner to avoid such disruptions.
The Committee next reviewed a charge on implications of the current abundant reserve environment for Treasury issuance. The presenters noted that the high levels of reserves created by the Fed’s asset purchase programs have contributed to a favorable backdrop for Treasury issuance. Reserve creation tends to be associated with deposit growth in the banking system, which in turn boosts bank demand for Treasuries, especially in circumstances when loan growth is tepid. Banks historically prefer Treasuries in the short to intermediate part of the curve, with over 75% of aggregated GSIB Treasury holdings in the less than 5-year maturity. Continued reserve growth is also supportive of non-bank private sector demand, notably from Money Market Funds (MMFs) who are large buyers of T-Bills. Finally, the presenters noted that continued growth in reserves was negatively impacting certain bank capital ratios (including Tier 1 leverage, SLR, GSIB) and could constrain bank balance sheet capacity for repo and Treasury purchases.
The Committee next reviewed a second charge on how Treasury should think about swap spreads in the context of borrowing costs. The presenters noted a range of factors that influence both swap rates and Treasury rates, including their differing investor bases, capital treatment, and the range of indices. Treasury supply is an important factor affecting the level of swap spreads, with increased deficits helping to drive spreads negative since 2008. However, Treasury supply is only one of many factors to consider. Hedging needs, regulatory changes, Treasury financing rates, credit conditions, and corporate supply can also influence the level of swap spreads.
The Committee discussed whether negative swap spreads at longer maturities should be interpreted as reflecting additional cost to the Treasury of issuing at those maturities. The Committee was in general agreement that negative swap spreads partly reflected such a cost to Treasury, consistent with how the Committee has interpreted those spreads in its discussions of previous charges. However, members also recognized that the negative spreads might also reflect structural excess demand to receive swaps, which could drive spreads negative without direct effects on Treasury’s funding cost. Moreover, members noted that spreads had widened over the second half of 2020, despite large increases in prospective Treasury issuance. Most attributed the recent widening to the exemption of Treasuries from the SLR and to the Federal Reserve’s ongoing support of the repo market. The Committee was in broad agreement that Treasury funding costs would likely move higher and that market functioning could become more fragile if this exemption was not extended or made permanent.
Treasury staff presented an overview of net issuance assuming coupon sizes remained the same as announced in FY21Q1. In that case, net coupon issuance this quarter would be $695bn, and the outstanding amount of T-Bills would decline by $421 billion to meet the projected financing need. At the end of December, private T-Bill holdings had reduced to $4,633 billion, just below recent all-time highs of $4,703 billion. T-Bills holdings as a share of marketable debt outstanding stood at 23.7% -- above the historical average of 22.7%. The Committee was pleased to see that WAM and TIPS share had both stabilized given recent auction size increases in coupons.
The Committee discussed financing strategies to accommodate revised fiscal projections amidst continued fiscal and economic uncertainty owing to the COVID-19 pandemic. While Treasury issuance was met with solid demand over the quarter, Committee members noted that the curve had steepened further since the November refunding, with 2-year notes 5 bps lower and 10- and 30-year tenors 15bps higher. Members pointed to several factors driving the curve steepening, including initial vaccine distribution, market expectations of further fiscal stimulus, and the Federal Reserve’s Flexible Average Inflation Targeting approach.
The Committee continues to believe that extending the maturity structure of Treasury debt, particularly through issuance of maturities out to 10 years, is desirable to reduce risks to funding costs and to limit operational risk from frequent issuance. Prior increases in coupon issuance will continue to result in sizable net funding to Treasury for several years and are expected to extend the weighted-average maturity of the debt over time. Given that observation, the Committee endorsed maintaining coupon sizes this quarter. The Committee felt that this approach would also leave it with considerable flexibility to adjust future issuance if needed, given the significant uncertainty about fiscal policy and the associated funding needs.
The Committee further recommends ongoing moderate increases in TIPS issue sizes. Given the meaningful increases in nominal debt issuance in 2020, TIPS share of outstanding debt has fallen to 7.5% from around 9% in the pre-COVID period. The Committee is supportive of increases in TIPS supply to gradually move their share of debt outstanding in the direction of pre-COVID levels, while monitoring market functioning and the relative valuation of TIPS to nominal securities as this adjustment takes place.
Overall, the recommended path of auction sizes should allow Treasury to continue reducing funding risk, while maintaining flexibility to accommodate further meaningful funding needs should they arise. The path would be expected to lengthen the average maturity of Treasury debt back to its pre-COVID levels over time. It would also leave the T-bill share of outstanding debt on a general downward trajectory over the next couple of years, toward the 15% to 20% range that TBAC had previously recommended. Of course, given the considerable uncertainty surrounding current fiscal projections, the economy, and the Fed’s balance sheet policy, Treasury will need to retain flexibility in its approach.
Finally, Committee members continue to encourage Treasury to announce a SOFR FRN. Members acknowledged the significant private and public sector work currently underway on the transition, despite the recent extension of paneled LIBOR to mid-2023. Treasury has been an active participant in ARRC and has provided helpful guidance on tax treatment of derivatives subject to the transition, but the Committee strongly believes that Treasury should also be a leader in terms of its issuance decisions. The Committee therefore continues to unanimously support Treasury issuance of a SOFR FRN. Specifically, the Committee expects that issuance by the Treasury would help to further establish market standards for notes, encourage technological investment, support development of a term rate, and increase liquidity of SOFR-indexed products. The Committee continues to encourage Treasury to finalize any remaining issues on security design and implementation, and move forward with issuing a SOFR FRN, as soon as practicable, ideally in FY2021.
Chair, Treasury Borrowing Advisory Committee
Vice Chair, Treasury Borrowing Advisory Committee
1It was noted that privately-held net marketable borrowing excludes rollovers of Treasury securities and Treasury Bills held in the Federal Reserve’s System Open Market Account (SOMA). Secondary market purchases of Treasury securities by SOMA do not directly change net privately-held marketable borrowing, but when they mature would increase the amount of cash raised for a given privately-held auction size by increasing the SOMA “add-on” amount.