Dear Mr. Secretary:
Over the past three months, data on the economy's performance and forecasts for the next year have become mixed. Indeed, signs of weakness persist. The unemployment rate rose from 5.4% in October to 5.8% in December. Payroll employment fell by almost 1 million jobs in that period, and most economists believe GDP fell in both the third and fourth quarters. The National Bureau of Economic Research declared that a recession began in March of 2001. On the other hand, other information, especially recent data, suggest that the recession may be drawing to a close. Weekly data on new claims for unemployment benefits have declined by over 100,000 over the past few months. Household spending has proven to be much more resilient than anticipated and consumer confidence has been rising. Orders for durable goods have increased and recent reports by the Institute for Supply Management have shown marked increases. Most economists expect a swing in business inventories to lead to positive GDP growth in the first and the second quarters of 2002. At issue among forecasts is whether household and business final demand will be strong enough to ignite a self-sustaining recovery and, if so, how strong that recovery will be.
Interest rates on most Treasury maturities have risen since our last meeting on October 30. Yields on 2-year notes have risen by about 40 basis points, on 5-year notes by 65 basis points, and on 10-year notes by about 60 basis points. At the November refunding announcement, the Treasury stated its intention to discontinue issuing 30-year bonds. This caused an almost immediate decline in the yield on 30-year bonds of almost 40 basis points, but the move was subsequently reversed. The yield on outstanding 30-year bonds are now about 25 basis points higher than at the time of our October 30 meeting. Yields on short-term Treasury bills have declined by 40 basis points for 3-month bills and 20 basis points for 6-month bills, in sympathy with the 75 basis point drop in the federal funds rate that took place in two installments in early November and early December. Spreads to Treasuries on corporate bonds, mortgage-backed securities, and swaps have all declined since October 30 but generally not enough to offset the rise in Treasury yields. Overall, fixed income markets appear to anticipate an end to Fed easing, an economic recovery, and at some point a rise in the federal funds rate from its current level of 1.75%.
The equity market has risen since October 30, with the Dow Jones Industrial Index up about 5%, the S&P 500 Index up about 4%, and the NASDAQ Composite up over 13%. However, the averages peaked in early January and are off about 7%, 6%, and 8%, respectively, from highs achieved on January 4. Company reports have become less pessimistic since our October 30 meeting. Data collected by First Call show that while the 129 negative pre-announcements or earnings warnings for the first quarter of 2002 are 12% above those recorded at the same point in the first quarter of 2001, they are 31% below those at comparable points in the second, third, and fourth quarters of 2001. In addition, positive pre-announcements have accelerated.
As noted in our October 30 report, the budget outlook is significantly different from what it was earlier in 2001. The Congressional Budget Office estimates a current policy deficit for the current fiscal year of $21 billion, compared to a surplus of $313 billion projected last year at this time and a surplus of about $150 billion projected as of mid-2001 after the tax cut was enacted. The CBO also now projects a deficit of $14 billion for 2003 and a surplus of $54 billion in 2004. However, these projections assume current policies are left unchanged. The President's budget is reported to contain proposals that would increase the deficit for the current fiscal year to over $100 billion and the deficit for 2003 to $80 billion. However, the President's proposal would still have the budget returning to surplus in 2004.
Against this economic and financial background, the Committee began consideration of debt management questions posed by the Treasury and the composition of financing to refund $4.1 billion of privately held Treasury debt maturing on February 15.
The first question posed by the Treasury asked what adjustments to financing plans should be made this year and next because of changes in the budget outlook. In particular, the Treasury asked what changes, if any, should be made in terms of the following:
- Issue size
- Reopening policies
- Types of securities and maturities
To begin with, the Committee report of October 30 had considered the effect on financing plans of the change in the budget outlook, under the assumption of a deficit/surplus projection that was roughly similar to the latest CBO current policy projection. At that time, the Committee concluded that the Treasury does not appear to have to make dramatic changes in its current coupon offering frequencies or sizes in fiscal year 2002 or even in 2003. The Committee believed at that time and continues to believe that the extra money raised in 2-year notes, now being issued at $25 billion per month, as well as some extra issuance in Treasury bills, will accomplish the bulk of the additional financing required in 2002 and 2003 as long as deficits fall within the ranges encompassed by the CBO current policy projections and would probably, with minor adjustments, cover the budget profile of the President's budget.
The CBO estimated that between 1981 and 2001 the average absolute divergence between their forecast for the budget deficit in the current year and the actual outcome because of economic and technical factors alone was the equivalent of about $60 billion, expressed in terms of the deficit for 2002. Current financing schedules are geared toward small to moderate deficits, with a return to surplus within the next few years. If budget outcomes are more favorable than now anticipated, with smaller deficits and a more rapid return to surplus, the current financing schedules can be modified at the margin, similar to what had been the trend prior to fiscal year 2002. On the other hand, it is conceivable that the combination of enactment of policy proposals equivalent in size to those in the President's budget and unforeseen economic and technical factors could result in significantly larger financing needs that would require changes to current financing schedules. If this were to occur, the Treasury could, in short, begin to unwind some of the financing changes made over the past several years. More specifically, the following represent a general list of alternatives and possible changes if unfavorable deficit outcomes develop.
- Issue size: The Treasury has increased the issue size of the 2-year note from $17 billion in September to $25 billion in January. Most members believe that the market is having some difficulty absorbing the increase, with two of the last three auctions having cover ratios of 1.5 to 1, the lowest for a 2-year note since 1988. One member disagreed, suggesting that auction procedures, such as single price auctions, were the problem. However, the majority believe that if the Treasury needs to raise more cash, it should next move to the 5-year note, where members believe the market could absorb increased issue sizes. Members expressed some ambiguity about making significant increases to 10-year note issuance. Some expressed skepticism about increasing 10-year note sizes if the budget is still going to return to surplus in a few years after a short period of higher deficits. If unfavorable budget outcomes appear to be pushing the date of the return to surplus back several years, all members agreed that 10 year-issuance could be increased.
- Reopening policies: The Treasury policy of reopening 5-year and 10-year issues in alternate quarters was formulated as a means of providing large liquid issues in a period of sharply rising budget surpluses. If an unfavorable deficit outcome results in a significant rise in issue sizes, it is not clear that the reopening policy would be needed and could even create cash management problems for the Treasury at maturity.
- Frequencies: Members are of the belief that it would take a very sharp deterioration of the deficit outlook for the current financing schedule, with larger issue sizes, to be insufficient to meet financing needs. If that outcome were to occur, clearly the Treasury could revert to more frequent 5-year and 10-year auctions.
- Types of securities: Finally, the Treasury could, in theory, re-institute discontinued new issue maturities, in the event that other changes did not satisfy financing requirements.
- Buybacks: A somewhat different question arises in the case of buybacks. The Committee recommended and the Treasury implemented debt buybacks in a period when surpluses were developing, and there were projections that the public debt would be paid down within the next decade. Buybacks were a useful way of maintaining market liquidity by making it possible to issue larger sizes of current coupons than would otherwise have been the case. A side benefit was interest cost savings to the Treasury. In a period of budget deficits, buybacks are not necessarily needed to enhance liquidity in current coupons. However, even in a period of overall deficit, the Treasury continues to have isolated windows when they have significant amounts of excess cash or surplus and buybacks are an opportune use of that excess cash. Some members believed that buybacks should be continued throughout the year even if at a lower level as long as the Treasury continues to believe the budget will eventually return to surplus. However, the majority believed that for the time being the Treasury might want to engage in buybacks primarily during months or quarters when they run surpluses. A continuation of the program under such circumstances would be less likely to be interpreted as an attempt to manipulate the yield curve but as a reasonable component in a program to manage cash positions that is also consistent with the belief that the budget will return to surplus at some point.
In response to Treasury's request for ways to enhance the development of the 10-year inflation indexed securities market, the Committee recognized that for a number of reasons including supply/demand imbalances and the current low-inflation environment, the IIs market remains an expensive debt management tool. Some member believe that the program has not been in existence long enough to fully ascertain whether it will ultimately require higher interest payments than on nominal securities, citing past experience with the introduction of the 30-year bond. Regardless, most felt that a number of program adjustments might help broaden demand for the product and eventually lead to more favorable financing terms for Treasury.
First, Treasury should reiterate their long-term commitment to the program. Despite broader acceptance among investors in recent years, many still are skeptical as to whether the Treasury will continue the program in any meaningful way.
Additionally, Treasury should upgrade its marketing program for IIs by highlighting, for instance, the deflation protection imbedded in new issue IIs as well as the non-correlated nature of the product as a portfolio management tool. This could help create more interest in the product among non-traditional IIs players.
Smoothing the new issue process by spreading issuance more uniformly throughout the year and moving auctions to more effective dates might create more interest in the auction process and alleviate some of the previously mentioned supply/demand imbalances. To accomplish this, Treasury should move from 2 to 4 auctions per year including 2 new issues and 2 reopenings. Additionally, Treasury should consider aligning the IIs new issues with the quarterly refundings when interest in Treasuries is at a peak. This change could increase crossover participation from traditional Treasury participants and generally increase focus on the product.
The next question from the Treasury had to do with the calculation of the net long position (NLP) as part of the auction process and efforts by the Treasury to reduce the time between submission of auction bids and announcement of results. Currently, net long positions for Treasury auctions are calculated as of 12:30 p.m. for a 1:00 p.m. auction close, and reportable net long positions are submitted along with bids for calculation of the 35 percent award limit. Would it be feasible to have the net long position calculation computed at 1:00 p.m., but reported after the close of an auction? Effectively, bidding entities would be responsible for net long calculations relative to amounts bid, and auction awards would be based solely on amounts bid. Net long positions for purposes of the 35 percent rule would be determined after awards are made. If this approach were taken, the Treasury asked what sanctions the Committee would recommend if an entity were found to be in violation of the 35 percent rule.
Most Committee members felt that separating NLP reporting from actual auction bidding and moving the reporting point from 12:30 to 1:00 p.m., while somewhat more burdensome to the bidder, was manageable practically. It might create some unintended consequences including smaller bid to cover rates and generally weaker auction results. In recent years the dealer community has improved its ability to calculate NLP quickly and accurately and because of this most Committee members felt that moving the NLP calculation from 12:30 to 1:00 could be accomplished easily. The self policing aspect of the 35 percent rule, however, was more troubling as it shifted the burden of staying within the 35 percent limit squarely from Treasury to the bidder. In the past, a bidder could submit multiple bids in excess of the 35% rule knowing Treasury would reduce the award to be conforming. Under the self policing method, however, the bidder would be in violation once the threshold bid was awarded in auction. To avoid this situation bidders would almost certainly place fewer auction bids leading to smaller bid/cover ratios and possibly to weaker auction results. The Committee felt strongly that any benefits to Treasury afforded by quicker turnaround time in these situations should be weighed against the potential for weaker auction results.
In response to the question of recommended sanctions if an entity were found to be in violation of the 35 percent rule, the strong majority of Committee members felt that current sanctions were appropriate if not onerous. Also, it was unclear whether the change in NLP reporting would lead to fewer or more violations of the 35 percent rule. Treasury could adjust sanctions in the future if material violations of the 35 percent rule increased.
Finally, the Committee felt that improving the electronic capabilities of the auction platform could both improve Treasury auction turnaround and increase investor participation in the auction. For instance, if a bidder were able to check all auction inputs electronically prior to submission, errors would be kept to a minimum while customer participation remained high and auction turnaround quick.
The Treasury asked for the Committee's recommendation on the composition of financing in 5- and 10-year notes to refund $4.1 billion of privately held bonds maturing on February 15, the composition of marketable financing for the remainder of the January-March quarter, and the composition of the marketable financing for the April-June quarter.
The Committee recommends a $15 billion reopening of the outstanding 5-year note due November 15, 2006 and a new $13 billion 10-year note due February 15, 2012. For the remainder of the quarter the Committee recommends a $25 billion 2-year note to be auctioned on February 27. The Committee does not recommend any cash management bills, projecting that the funding that would normally take place in cash management bills will be accomplished by increasing the size of 4-week bills to a high of $23 billion in mid-March as shown in the attached table.
For the April-June quarter, the Committee's recommended financing is contained in the attached table. However, three salient features of the recommendation are worthy of note.
First, the Committee suggests an $18 billion new issue of 5-year notes, to be auctioned on May 7. This larger initial size for the 5-year is consistent with the Committee's October 30 recommendation that the initial issue size for 5-year notes should be larger relative to the reopening so that more securities are available for hedging purposes during the initial three months when the issue's usefulness as a hedge is at its best.
Next, the financing plan for April-June includes a $3 billion reopening of the January inflation indexed 10-year. Committee members believe that making the indexed security part of the refunding would call attention to the issue and would enhance somewhat the development of the indexed market. Some members believed $3 billion was too small an issue size, even for a reopening. However, the majority believed the amount was a good starting point if the Treasury decides to include indexed securities in all four refundings.
Finally, the Committee recommendation for the April-June period includes a $12 billion (approximately $9 billion par amount) purchase of outstanding long-term bonds by the Treasury, concentrated in the period of maximum Treasury cash balances, approximately April 17 to May 15, consistent with the earlier discussion of buybacks in this report. Some members believed $12 billion was too large an amount for repurchases in a one-month period, but the majority believed the market could accommodate the repurchase. Also, a few members advocated that repurchases be spread throughout the year. However, the majority felt the market would be skeptical of the Treasury's motivation for such a policy while the government is running deficits and, as a result, advocated concentrating the purchase during periods of large, excess cash balances.
James R. Capra, Chairman
Timothy W. Jay, Vice Chairman
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