U.S. Department of the Treasury

Dear Mr. Secretary:

 

Since the Committee's last meeting on April 30th, the economic recovery has continued to unfold, but the risk of collateral damage from the stock market has grown. Economic indicators remain positive. The labor market shows signs of moderate growth. Consumer spending has remained solid. Spending on both housing and motor vehicles remains at elevated levels. The pace of inventory decline continues to slow. And there are even tentative signs of a pick-up in business spending. However, financial conditions have worsened noticeably. Credit markets continue to tighten, with wider spreads and reduced supply. The S&P 500 has fallen nearly 25% since mid-May, cutting household wealth by more than $3 trillion. This negative shock has been partially offset by a 10% or so decline in the trade-weighted dollar and falling interest rates. Overall, the risks to second half growth have increased, although there is considerable disagreement among economists about the amount of collateral economic damage from the drop in the stock market. Meanwhile, inflation indicators remain subdued.

 

Interest rates have fallen sharply since our last meeting. Despite improvements in the economic data, ongoing weakness in the equity markets helped push 2-year yields down roughly 100 basis points since April 30th while the 10-year note has fallen roughly 75 over the same period.

 

In the credit markets there has been a flight to quality.  Mortgage-backed option adjusted spreads narrowed from 50 basis points on April 30th, to 45 basis points on July 24th. Going down the credit spectrum spreads widened.  Aa rated industrial bond spreads widened marginally from 85 basis points to 100 basis points.  Baa spreads widened from 275 basis points to 330 basis points.  High-yield spreads widened from 692 basis points to 937 basis points.  In this last, lowest rated class, the arrival of large new downgraded issues was a particularly heavy burden.

 

The market focus on accounting issues has intensified further since April. Several high-profile firms have acknowledged bookkeeping irregularities and sentiment in the market has turned sharply negative despite healthy economic news. As a result, equity market averages are down across the board. The Dow Jones Industrial average has fallen 20%, the S&P 500 has fallen 25%, and the NASDAQ is down 27%.

 

The budget situation has continued to deteriorate as increased security-related spending and decreased tax receipts should result in a budget deficit of $165 billion in FY2002, almost double the estimate reported by this Committee in April. Deficit estimates for FY2003 reflect the continued uncertainty regarding the true cost of both the Administration's policy towards the war on terrorism and the recent equity market downturn. At present, budget deficit estimates for FY2003 run between $150 billion and $200 billion.

 

Against this economic and financial backdrop, the Committee began consideration of various debt management questions posed by Treasury including the composition of financing to refund $18.8 billion of privately held notes maturing on August 15.

 

Before tackling the broader refunding question, the Committee first addressed the question regarding the regular reopening policy for 10-year notes.  Some Committee members felt that because Treasury forecasts are predicting a return to budget surplus by 2005, Treasury would be premature to end the reopening policy.  Under most scenarios Treasury could borrow at least through the end of 2003, without increasing their 10-year issuance.  This could be achieved by continuing to focus increased issuance in treasury bills, 2-year notes and 5-year notes.  Some members thought that a change in the 10-year reopening policy at this point would lead some market participants to surmise that Treasury had pushed surplus projections further into the future.  Treasury securities might suffer under this scenario as the market braced unnecessarily for added supply.

 

The majority of members, however, felt that ending the reopening now made sense for a number of reasons.  First, by many estimates incremental issuance in maturities less than five years would be costly to Treasury on a relative value basis as these sectors had moved to historically cheap levels versus other asset classes, and against similar maturity off the run issues.  Second, single cusip 10 years would be a more attractive hedging vehicle as duration drift would prove less of an obstacle.  This in turn would probably lead to higher trading volumes, more underlying repurchase agreement activity and more advantageous pricing for Treasury.  In addition, some members felt that given the questionable accuracy of deficit forecasting as well as the somewhat asymmetric risk regarding higher deficits over the next year, moving to single cusip 10-year issuance now would add flexibility to Treasury debt management.  In this light, the Committee voted 14 to 3 to recommend ending the automatic reopening in the 10-year note with the current refunding announcement.

 

In response to Treasury's question regarding the minimum size of single cusip 10-years, most members felt that from both the prospective of risk transferral at auction and liquidity to support the benchmark status of the sector, $15 billion represented the appropriate minimum size.

 

The Committee then turned to the question involving the composition of five and ten year notes to refund $18.8 billion of privately held notes maturing August 15, the composition of Treasury marketable financing for the remainder of the July-September quarter, including cash management bills if necessary, and the composition of the marketable financing for the October-December quarter.

 

The Committee recommends a new $24 billion 5-year note due August 15, 2007 and a new $15 billion 10-year note due August 15, 2012.  For the remainder of the quarter, the Committee recommends two $27 billion 2-year notes to be auctioned on August 28 and September 25.  The Committee does not recommend any cash management bills projecting that any increased short-term cash needs be satisfied by adjusting up the size of 4-week bills to a high of $25 billion in mid August as shown on the attached table. 

 

For the October-December quarter the Committee's recommended financing is contained in the attached table.  Relevant features include three $28 billion 2-year notes and one $25 billion 5-year note, all slightly larger than in the previous quarter.  The Committee further recommended a $15 billion single cusip 10-year note and $6 billion of a reopened Treasury Inflation Protected Security due July 10, 2112 which follows Treasury's previous guidance regarding TIPS issuance.  Again, in this quarter no cash management bills are recommended.

 

Treasury currently announces auctions for marketable securities at 2:30 p.m. and conducts auctions at 1:00 p.m. a few days later.  The Treasury asked the Committee if debt management would benefit from moving announcements and auctions to earlier in the day and from reducing the time between announcements, auctions and settlements.

 

Regarding moving auction announcements forward, most members felt that informing as many participants as possible during active morning trading would lead to increased liquidity.  Additionally, it would benefit overseas participants without significantly affecting domestic participants.  As a result, the Committee felt there was little downside to making the change and recommended moving the announcement time forward to 11:00 a.m.

 

Members of the Committee were resistant to moving the timing of the auction process forward.  Some Committee members felt there was a clear value to Treasury owning the 1:00 p.m. time slot for underwriting securities.  Many suggested that any move to a new time slot might undermine the underwriting process most of which occurs on the actual auction day.  Ultimately, the Committee felt that the vast majority of actual underwriting continues to be done by the primary dealer community and as a result, Treasury auctions should remain in the 1:00p.m. time slot. 

 

A reduction in time between the announcement and the settlement of securities was also discussed by the Committee.  This is a topic the Committee has been in favor of in the past, as it reduces systemic counterparty risk as a result of a narrower time frame for the underwriting and auction processes.  It was suggested that the amount of when-issued trading volume (ex-rolls) has been contracting consistently over the past several quarters, making this period less relevant. As a result a shorter period could be considered.  With treasury bills, the time period between announcement and auction has successfully been shortened, and the Committee felt the announcement to auction period for coupons could be shortened as well.  The result would reduce systemic risk without sacrificing adequate underwriting opportunity.

 

The Committee noted at their prior meeting in April that a higher level of volatility is probably a permanent feature of the credit markets.  Treasury asked the Committee if they felt Treasury's current issuance pattern and calendar was well placed to meet their objective of low cost borrowing over time.  Specifically, do sizes and frequency of issuance mitigate the risks associated with episodes of high volatility, and should Treasury consider offering coupon securities more frequently or in a wider range of securities.

 

Committee members felt that the effect of smaller size and more frequent issuance patterns could have a negative effect on coupon markets.  By reducing the size of auctions, the potential for less liquid benchmarks would exist possibly leading to higher borrowing costs to Treasury.  The Committee also felt the smaller issuance size could have the effect of driving participants away from the auction process, as issuance size would be less relevant to their portfolios.  Additionally, by spreading out their issuance across a wider set of auctions, Treasury might appear to be timing the markets, which has not been the policy of the Treasury debt management in the past.  Finally, one member suggested that maintaining the current issuance pattern left the calendar relatively free for other market participants such as corporates, supranationals and federal agencies to access the primary market.  As a result the Committee recommends that Treasury maintain its current policy of a larger, less frequent issuance calendar.

 

Respectfully submitted,

Timothy Jay
Chairman

 

Mark Werner
Vice Chairman