FROM THE OFFICE OF PUBLIC AFFAIRS
Dear Mr. Secretary:
Since the Committee's last meeting on January 30, the Commerce Department has issued releases for GDP for the fourth quarter of 2001 and the first quarter of 2002 showing real growth of 1.4% and 5.8% respectively. These surprisingly strong reports were accompanied by reports of subdued, in fact, slightly declining inflation. Nevertheless, doubts persist over the strength and sustainability of the expansion. Pessimists cite temporary factors, such as auto financing incentives, unseasonably warm weather, and accelerated issuance of tax refunds for the robust consumer demand and residential construction over the two quarters. Concerns include the lack of response yet in business fixed investment and employment, recent increases in crude oil prices and weak stock and bond markets. Optimists believe that the continued stimulus of fiscal policy, still low short-term interest rates, and a slight decline in the dollar will combine to produce a solid and self-sustaining expansion over the coming quarters.
Interest rates have risen in Treasury coupons since our last meeting. The change represents the net result of a very sharp sell off in March, as strong data on the fourth and first quarters created a wave of optimism about the economy, and a strong rally in April as doubts about the sustainability of the expansion and geopolitical tensions began to surface. On balance, 2-year note yields are about 20 basis points higher than on January 30, while 5-year and 10-year note yields are about 10 basis points higher. The rate on 3-month bills is unchanged.
In other credit markets, spreads to Treasuries have been mixed. Spreads on corporate Baa credits have widened somewhat, high yield spreads have narrowed considerably, and Aa spreads are roughly unchanged. Spreads on mortgage-backed securities have narrowed.
An important financial market development over the past three months has been an intensifying focus on issues of accounting and financial disclosure, triggered by several high profile bankruptcies. A rally in the equity market in March triggered by upbeat news on the economy was subsequently undermined by renewed concerns over financial disclosure and concerns over the sustainability of recent improvements in profitability. As a result, equity market averages are mixed relative to January 30. The S&P 500 is down 3.3 percent, while the Dow Jones Industrial Average is up 1.9 percent, and the NASDAQ Composite is down 11.8 percent.
Another important development since January 30 has been a sharp deterioration in the short-term budget outlook and the Treasury's financing requirements. Tax receipts in April have been approximately 30 percent lower than those received last year. This result together with the enactment of the legislation extending unemployment benefits and cutting certain business taxes has led the Treasury to alter its second quarter borrowing requirements from an $89 billion paydown with a target for the cash balance on June 30 of $60 billion to a $1 billion borrowing with a $45 billion cash balance target for June 30. Most economists now believe the budget deficit for fiscal year 2002 will turn out to be between $80 billion and $100 billion.
Composition of Financing for the Second and Third Quarters
The Treasury asked for the Committee's recommendation on the composition of 5- and 10-year notes to refund $9 billion of privately held bonds maturing on May 15, the composition of Treasury marketable financing for the remainder of the April-June quarter, including cash management bills if necessary, and the composition of Treasury marketable financing for the July-August quarter.
The Committee recommends a new $20 billion five-year note due May 15, 2007, an $11 billion reopening of the 10-year note due February 15, 2012, and a new $4 billion inflation index security (IIS) due May 15, 2012. For the remainder of the April-June and the July-September quarters, the Committee's recommended financing is contained in the attached tables. Several features of the recommendations for the April-June quarter, however, are worthy of note.
Most Committee members felt that in light of likely increases in medium-term budget deficit projections, probably extending into 2004, the Treasury should end the automatic reopenings policy for the 5-year note. This would allow for larger quarterly issuance in the sector without lumping maturities or creating reopened issues too large and cumbersome for the markets. Most Committee members felt that $20 billion should represent the minimum auction size for the 5-year but expressed no opinion on auction maximums as long as sizes are increased gradually over time. For some time the Committee has held the view that the reopening policy on the 5-year note presents some problems because of the reduced effectiveness of the issue as a hedging vehicle in the second half of its term as the current coupon. It should be noted that the Committee does not believe that ending the automatic reopening policy for the 5-year precludes discretionary reopenings by the Treasury in the future. The change suggested by the Committee is consistent with its prior recommendation of potential changes that the Treasury could make if the budget outlook were to deteriorate.
In addition, while a few Committee members felt that Treasury should announce their intentions relative to the 10-year note reopening policy, the majority felt that given the same budget forecasts, it would be premature to announce any changes to 10-year note issuing policy. This would leave Treasury more flexibility going forward should the budget numbers improve as expected.
The Committee also reaffirmed its view that Treasury should move IIS auctions to the refunding period. Smoothing the new issue process by spreading issuance more uniformly throughout the year and moving auctions to more frequent and effective dates would attract broader client participation. This would mean more attractive pricing for the Treasury. Moving the auction to the refunding week would also solidify market perception of inflation indexed securities as a permanent feature of the Treasury's funding process. Market liquidity and focus is at a maximum at the time of the quarterly refunding. The Committee recommends that the Treasury auction two new issues and two reopenings yearly on the Thursday of the refunding week.
Finally, the Committee then revisited its previous contention that monthly two-year issuance be capped at $25 billion. While some members felt that increased bid to cover ratios in recent auctions might warrant larger two-year auction sizes, the majority believed that not enough data existed to make the case that auction sizes could be increased without risking Treasury's stated issuing goals, and 2-year issuance should remain at current levels until more data became available.
Average Maturity of the Debt
In Treasury's chart presentation, the chart of the average maturity of the privately held marketable debt was shown to have turned lower in the year 2000 and now stands at 5 years 9 months. Under current financing schedules, this trend will continue so that by the end of 2002 the average maturity will have fallen to under 5-1/2 years. The Treasury asked for the Committee's views on what factors regarding the composition of outstanding debt and new debt issuance should be considered in the formulation of debt management policy. The Committee first noted that the average maturity of the debt has fluctuated between four and six years for forty of the past fifty years. The current numbers all well within those ranges. Members felt that the Treasury's long-range expectations for the federal budget should be an important component in the composition and maturity of the debt. However, because of the inherent economic and political uncertainties in long-range budget projections, these should not be the sole or, according to some, even the most important factor in decisions about the debt. Some Committee members expressed the opinion that under most circumstances, the most important consideration for the Treasury is to be able to easily raise money to fund the government and to be able to do so under any and all circumstances, regardless of the business cycle. While it may be temporarily less expensive for the Treasury to raise all of its funds in very short maturities, rollover risk related to the business cycle and even to foreign participation in the U.S. market suggests that in the long run such a policy could actually increase direct and indirect costs. Another consideration that was important to Committee members, even most important to some members, is the use of Treasuries for risk transference, that is hedging, from other markets like corporates and mortgages. These markets have been growing rapidly in recent years. It was noted that while the amount of Treasury coupons has contracted in recent years, the volume of trading in Treasuries has actually increased because of the use of Treasuries for risk transference. Members believe that providing new liquid debt in maturities where hedging requirements are the greatest not only helps the functioning of these markets but over the long run reduces the cost of debt to the Treasury. By and large, members expressed the view that changes in the average maturity of the debt within the broad ranges of four to six years are not critical in and of themselves to Treasury debt management.
Occasionally, situations arise where it may be important to change the trend movement in the average maturity. For example, a few years ago when officials became increasingly convinced that budget surpluses were going to grow quickly so that all the debt would be paid down by 2011, a rising average maturity of the debt did not appear consistent with the expectations and goals of the Treasury. As of now, the average maturity has turned down and the date of a potential paydown of the debt has been pushed further into the future. Consequently, Committee members expressed the belief that other factors such as maintaining a variety of maturities to protect against rollover risks throughout the business cycle and providing securities that are available for risk transference purposes are now more important considerations when deciding on the composition and maturities of debt financing.
Cash Management Alternatives
Since August 2001, the issuance of 4-week bills has helped to smooth the fluctuations in the Treasury's cash balances. The Treasury asked the Committee for its opinion on two other cash management alternatives, namely the buyback of short-dated securities and the execution of term repurchase agreements. As background, the Committee noted that in several months during the year, the Treasury cash balance swings are intra-monthly events with balances being low in part of the month and rising to very high levels in other parts, especially after tax dates. With the capacity of tax and loan accounts being limited to about $55 billion and 4-week bills being an inefficient means of dealing with such an intra-monthly problem, Committee members believe that both buybacks of short-dated debt and term repos are appropriate tools to address these cash balance fluctuations. Members do not believe that the actions are justified primarily by the very slight increase in interest earnings on the cash balances relative to the interest received on tax and loan balances but more by the need for additional alternatives as limits on these balances become binding. Members assumed that the conduct of term repos could be coordinated with the Federal Reserve which conducts similar operations from time to time.
In response to Treasury's question regarding the existence of increased volatility as an ongoing feature in credit markets and the implications for various asset classes, the Committee noted that certain aspects of increased volatility were cyclical and others secular. Cyclical causes included economic uncertainty and low interest rates, as they interact with hedging adjustments. Increased mortgage concentration, convexity risk and corporate issuance as well as the accompanying growth in the derivatives market are more secular in nature. Most felt that volatility extremes witnessed last fall resulted from a confluence of many diverse events and probably would not be repeated in the near future. However, increased volatility for any given level of interest rates is probably a permanent feature of the markets because of secular trends in the mortgage and corporate markets.
Finally, most Committee members viewed Treasury's securities as the risk transfer vehicle of choice despite negative supply trends in recent years. Over time they felt the status should be a benefit to Treasury and, under certain circumstances, might affect the size and maturities of new debt issuance.
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