May 5, 2020
Letter to the Secretary
Dear Mr. Secretary:
Economic activity fell in the first quarter of 2020, with a 4.8% annualized decline in real GDP. The ongoing coronavirus outbreak has weighed heavily on the US economy, with activity expected to fall sharply further in the second quarter of the year. Going forward, the coronavirus and weak global growth will be significant headwinds, while a large fiscal boost in response to the virus will provide some offset for the remainder of the year. We applaud the efforts of Treasury, Congress and the Federal Reserve which were swift, deliberate and highly effective at reducing financial market volatility and will hopefully reduce the economic impact of the many shelter in place orders throughout the country.
Since the Committee last met, the Federal Open Market Committee (FOMC) lowered the target range for the federal funds rate by 150bp to the effective lower bound of 0%-0.25%. Overall financial conditions tightened sharply in the early stages of the coronavirus outbreak, but have eased somewhat over the last month. Equity prices declined roughly 14% on net since the last refunding, with a nearly 13% increase in April. The 2-year Treasury yield and the 10-year Treasury yield both declined significantly on net. The trade-weighted dollar index has increased roughly 7% on net since the Committee last met.
Consumer spending fell at a 7.6% annualized rate in the first quarter, the largest quarterly decline since 1980. Services spending decreased at a 10.2% rate and durables goods spending decreased at a 16.1% rate. Non-durables spending increased at a 6.9% rate, largely driven by an increase in food and beverages consumption. Measures of consumer confidence and consumer sentiment have pulled back significantly, but still remain above levels during the last recession. Job losses and closures of many businesses will weigh on consumer spending in the coming quarters, while income replacement from fiscal stimulus will help to provide an offsetting boost.
Business fixed investment fell at an 8.6% annualized rate, declining for the fourth consecutive quarter. Structures investment declined at a 9.7% annualized rate and equipment investment fell at a 15.3% rate, while investment in intellectual products increased at a 0.5% rate. The change in inventory investment subtracted 0.5 percentage points from GDP growth in the first quarter. Regional manufacturing surveys deteriorated significantly in April, with many showing their lowest reading on record. Anecdotes from manufacturers have indicated a large decline in output from factory closures, supply chain disruptions, and lower demand. A large decline in oil prices has also weighed on capital expenditures in the energy sector.
Residential investment increased at a 21.1% annualized rate in the first quarter, its third consecutive quarterly increase and the largest increase since 2012. However, new home sales, housing starts, and permits all fell in March, and surveys of home builders have indicated a very low level of optimism. Mortgage rates declined significantly over the last year, which has provided a boost to housing activity.
Net exports contributed 1.3pp to real GDP growth in the first quarter, as real exports decreased at an 8.7% annualized rate while real imports fell at a 15.3% annualized rate, the fastest pace of decline since the previous recession. Federal spending increased at a 1.7% annualized rate in the first quarter, while state and local spending increased at a 0.1% rate. The federal deficit is expected to increase sharply this year largely due to fiscal relief measures including aid to unemployed workers and state and local governments, tax cuts and payments to individuals, and loans and tax benefits for businesses. The Congressional Budget Office’s most recent deficit projections estimate a 17.9% deficit in fiscal year 2020.
The labor market has rapidly deteriorated. Nonfarm payrolls fell by 701,000 In March after increasing by 245,000 per month in the first two months of the year. The unemployment rate increased by 0.9pp to 4.4% in March, while the broader underemployment rate increased by 1.7pp to 8.7%. The labor force participation rate declined by 0.7pp to 62.7%, and the employment-to-population ratio declined by 1.1pp to 60.0%. The unemployment rate will rise sharply further, as jobless claims have spiked to record levels and have totaled 27.9mn over the last six weeks.
Consumer price inflation has remained fairly soft. The total personal consumption expenditures price index rose at a 1.3% annualized rate in the first quarter, while the core measure excluding food and energy rose at a 1.8% rate. The core measure rose 1.8% over the last four quarters, but declined slightly in March. While the coronavirus has delivered large hits to both demand and supply, the near term effects on inflation appear disinflationary thus far, with the collapse in demand in certain sectors outweighing any inflationary supply pressures.
In addition to cutting the funds rate to the effective lower bound, the FOMC has also indicated that the funds rate will remain at the lower bound for an extended period. The Fed has also committed to purchasing Treasury securities and agency mortgage-backed securities as needed to support market functioning, and has introduced a number of new facilities to support the flow of credit. These include programs to provide credit to small and medium size businesses and state and local governments, facilities to buy corporate bonds in the primary and secondary markets, central bank swap lines, and facilities to boost liquidity for commercial paper, money market mutual funds, and asset-backed securities. These actions have significantly helped to reduce market volatility and illiquidity, and Fed officials have indicated the willingness and ability to intervene further if needed.
In light of this financial and economic backdrop, the Committee reviewed Treasury’s May 2020 Quarterly Refunding Presentation to the TBAC. Q2 2020 receipts were $96 billion (6%) higher than the same period in 2019. Total outlays over the same period were $149 billion higher, an increase of 7% relative to the comparable period in 2019. Based on the Quarterly Borrowing Estimate, Treasury’s Office of Fiscal Projections currently projects a net privately-held marketable borrowing need of $2,999 billion for Q3 FY 2020, with an end-of-June cash balance of $800 billion. This estimate is $3,055 billion higher than announced in February, driven by expenditures from new legislation to assist individuals and businesses through the COVID-19 outbreak. For Q4 FY 2020, the net privately-held marketable borrowing need is estimated to be $677 billion, with a cash balance of $800 billion at the end of September. The Committee agreed that it was important to maintain a higher cash balance over the near term given the significant uncertainty in timing of inflows and outflows given increased fiscal expenditures and delayed tax dates.
It 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.
Treasury staff presented an overview of net issuance assuming coupon sizes remained the same and not accounting for the addition of a 20- year maturity. In such case, net coupon issuance would be $249bn and T-Bill issuance would need to increase by $2,750 billion to meet the projected financing need. At the end of March, private T-Bill holdings had increased to $2,331 billion – close to the all-time highs, though T-Bills holdings as a share of total private holdings remained nearer to the lows at 17%. During the month of April, Treasury issued a further $1.4 trillion of T-Bills, taking the share of debt to over 20%. Treasury staff highlighted that demand for T-Bills remained robust throughout the recent issuance, bid-to-cover ratios remained stable across the curve, and foreign demand increased modestly.
The Committee next reviewed a charge on the impact of recent events on financial markets broadly and Treasury market liquidity. The presenter highlighted significant market dislocation during March as most of the US moved to social distancing and sheltering in place. The presenter reviewed the significant monetary policy and fiscal response which has restored the market to near normal functioning, including growth in the SOMA portfolio of approximately $1.5 trillion. Finally, the Committee reviewed in greater detail the expected buyers for Treasury debt issuance which will be required by the fiscal response to Covid-19. The Committee anticipated that demand for T-Bills would continue to be robust given the strong shift in flow of funds to deposits and money market funds. The Committee also expected that long end issuance would be reasonably well received by pensions, insurance companies and mutual funds. However, given the low level of rates and conviction that the zero lower bound would hold, it was suggested that yields might need to rise to accommodate the unprecedented expected issuance.
The Committee discussed financing strategies to accommodate significantly revised fiscal projections, continued expansion of the Federal Reserve SOMA portfolio and a new 20- year point. The Committee generally agreed that while T-Bills would need to act as a shock absorber in the near term, Treasury should increase the supply of coupons over time to mitigate the increase in roll over risk and short rate risk (from both increased T-Bill issuance and SOMA portfolio growth, as discussed at the February 2020 meeting where the concept of a consolidated Treasury/ Fed balance sheet was introduced). The Committee endorsed a gradual increase of coupon sizes in line with Treasury’s regular and predictable issuance strategy to achieve the lowest cost to taxpayers over time.
The Committee reiterated that WAM is not an explicit target. However, given near term expected T-Bill issuance, WAM is likely to shorten beyond desirable levels. The Committee also noted that over 30% of Treasury debt will be maturing within 1 year. Thus, the Committee recommended increases to coupon issuance with the front-end rising nominally and proportionally more than longer-end supply. Members highlighted that recent market dislocations were particularly severe in the long-end, and cautioned Treasury to move deliberately in that sector to ensure supply is well absorbed by real money buyers.
While in the near term T-Bills will likely represent a majority of issuance, the Committee agreed that over time the Treasury should try to maintain a share of T-Bills outstanding within historical ranges, and that further study was needed on the optimal T-Bill share of debt outstanding.
Next, the Committee recommended Treasury continue with its plan to begin monthly 20- year issuance this quarter, beginning with a $14 billion inaugural issue during the week of TIPS auctions, and $12 billion reopenings in the following two months. The Committee expected that auction sizes would gradually increase over coming quarters.
Given the uncertainty inherent in fiscal projections and Fed balance sheet policy, Treasury will need to retain flexibility in its issuance path to respond to further changes in funding needs, market functioning and shifting demand preferences.
Chair, Treasury Borrowing Advisory Committee
Vice Chair, Treasury Borrowing Advisory Committee