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Treasury BAC Minutes pt 2: No inflation worries here!
We commented yesterday on the absurd (or threatening) hypothesis postulated by a member of the Treasury Borrowing Advisory Committee that the Fed would drain all (yes, we still stand by that interpretation) $1 trillion in excess reserves by the end of March, 2010. Though the Committee is only advisory in nature, it is populated by the upper echelons of fixed income, such as JP Morgan (Chairman), Goldman Sachs (Vice Chairman), Soros Fund Management, and Pimco. The members also provide detailed suggestions as to future Treasury auctions. Accordingly, we read with great interest their thoughts on the future supply and demand of Treasury debt, especially with respect to Treasury’s stated interested in lengthening the average maturity of its debt profile. We were not disappointed, as the Minutes give a fascinating glimpse into a world where inflation is relegated to a marketing device, and passing the buck to the last bondholder is a game unto itself.
Again, we’ll quote directly from the Committee’s minutes:
[Debt Management] Director Ramanathan then turned to [Office of Management and Budget]'s midsession review, which included a table illustrating the effect of budget proposals on projected deficits. The updated 2010 projections' baseline estimates placed the deficit to GDP just above 4% for 2010-2014. Ramanathan noted that any significant variation in debt to GDP or decline in GDP growth in the coming years could increase Treasury's funding cost.
First, forget any variation in debt to GDP or decline in GDP. At even the projected levels, it’s nearly inconceivable that the bond vigilantes would allow the US to run a deficit to GDP of 4% over the next five years. However, that’s a topic for another day.
Despite these significant headwinds as well as issuance for Federal Reserve liquidity initiatives, the multi-tiered approach implemented by Treasury to meet these large financing needs ultimately served to stabilize Treasury's average maturity and actually shifted its direction higher. The reintroduction of the 3-year note and 7-year note as well as aggressively moving to two reopening in the 10-year note and 30-year note took place in an extremely compressed period of time, but led to minimal market disruption.
Inasmuch as creating artificial demand for Treasury securities through quantitative easing while encouraging the liquidity to be pumped into high beta equities is not market disruption.
DAS Rutherford reviewed the composition of the portfolio, noting that bills as a portion of the debt outstanding fell to about 27%, while bills excluding the SFP program fell to close to historical averages of 23%. DAS Rutherford noted that Treasury will work in close consultation with the Federal Reserve in considering the future path of the program.
Looking at the a number of forecasts for the next three years, DAS Rutherford pointed to continued reliance on nominal coupon issuance as well as additional issuance of inflation indexed securities to meet the large borrowing needs while shorter dated issuance eased. By gradually increasing coupons incrementally over the next three years, DAS Rutherford expected the average maturity of the debt to increase back to the historical average of 60 months [from a current 54 months] by fiscal year-end 2010. Eventually, though it could take five to six years, Treasury's marketable debt portfolio will stabilize at a new level between six to seven years [72 to 84 months].
Furthermore nominal coupons have risen to 65% from 57% of the portfolio, with particular reliance on the 5-year coupon, while TIPS have fallen to about 8% of the portfolio. Given recent dealer estimates of $1.4 trillion for the fiscal year 2010 deficit and marketable borrowing needs estimates between $1.2 trillion and $1.75 trillion, DAS Rutherford expected the current trends in issuance to continue but cautioned that the outlook remained uncertain as demonstrated by the $550 billion range in marketable borrowing expectations.
DAS Rutherford noted that deficit projections remain unacceptably high and that he expects the FY2011 budget to outline ways to address this. He did inform the Committee, however, that given the number of TIPS coming due early next year and Treasury's sizable borrowing need, TIPS as a proportion of the overall portfolio may continue to decline.
To better understand the reason for the shifts in the composition and profile of the portfolio, DAS Rutherford reviewed the circumstances of last year that sparked the decline in average maturity, noting that the bulk of bill issuance occurring last fall. DAS Rutherford discussed Treasury's maturity profile, noting that over the next 5 years, 73 days will have maturities greater than $20 billion and 46 days will have maturities greater than $30 billion. DAS Rutherford noted that approaches to addressing these sizable maturities will be a topic for TBAC discussion in the future.
While it may seem trivial at first glance to increase the average maturity from 54 to 84 months, this is a 56% increase. Further, a full 35% of the current Treasury debt portfolio ($2.5 trillion) matures by the end of FY2010 and must be rolled over, in addition to the new debt that must be issued to cover the estimated FY2010 deficit of $1.25 to $1.75 trillion. To raise the average portfolio maturity to 60 months in FY2010 requires new issuance of Treasurys with a weighted average maturity of between 34 and 37 months, respectively, depending on the actual deficit. Contrast this with the average weighted maturity issued during FY 2009 of 19 months (29 months excluding all cash management bills). Accordingly, even without a need for short duration emergency funding, the task for Treasury is challenging.
DAS Rutherford then addressed Treasury's intention to eliminate the 20-year TIPS [inflation linked securities] and reintroduce the 30-year TIPS. Citing an internal ODM report, DAS Rutherford noted zero-coupon inflation swaps data depicts inflation to be upwardly sloping. Assuming that 10-year forward and 20-year forward inflation expectations are not much different, Treasury would be capturing more inflation risk premium by extending issuance from 20-year to 30-year, making 30-year TIPS more cost effective for debt management.
Left unnoted is the fact that the inflation risk premium exists because of actual inflation risk. Of course, it is possible that inflation could magically disappear after 2029, but the worry-free quest for yield makes one wonder if there is any intent on making good on these long dated obligations.
With the presentation complete, DAS Rutherford asked the Committee for its thoughts on debt issuance and the policy changes being considered.
Another member stated that the GAO study pointed out that there are two potential valid ways of considering the cost of TIPS – an ex-post analysis and ex-ante analysis. Ex-post analysis, over the last 13 years, had shown that TIPS were an expensive form of financing for the government; by other metrics, including asset swaps and auction tails, Treasury was paying a premium to issue TIPS. Another member stated that on an ex-ante basis, TIPS appeared to be less expensive than on an ex-post basis. Another member stated that it would take years to determine if ex-ante analysis is the correct way of measuring TIPS costs.
The Committee opened with a discussion on TIPS and the idea of eliminating the 20-year TIPS in favor of 30-year TIPS. One member began by discussing the September 2009 GAO Study "Treasury Inflation Protected Securities Should Play and Heightened Role in Addressing Debt Management Challenges" (http://www.gao.gov/new.items/d09932.pdf). One member stated that the study was generally balanced and that the study highlighted reasons why there were market perceptions that the Treasury was not committed to the program.
This speaks to the heart of government analysis. When actual numbers don’t look good, figure out an alternative method and project them more favorably. Presumably, by 2020, we will have the expertise to determine if inflation is costly, even with the gamed CPI numbers.
A member stated that the measure of TIPS cost should perhaps be broadened so as to consider any positive externalities associated with the government accepting the risk to sell inflation. The member stated that investors may perceive the government's willingness to short inflation as a sign that policy makers are confident that inflation is contained.
While we recognize the old maxim “Don’t fight the Fed[/Treasury]” along with the self-fulfilling nature of public confidence in the markets, this is either the most cavalier, hubristic assessment of inflation risk we’ve read to date, or the member is throwing down the gauntlet against the bond vigilantes.
Also, issuing TIPS may be pro-cyclical and serve as a hedge to the government's balance sheet. Another member pointed out, however, that the government currently issues significant amounts of short-dated Treasury bills which are less expensive to the taxpayer and could be considered to be "pro-cyclical issuance". The member noted that the "pro-cyclical benefits" argument for issuing TIPS also breaks down in stagflation environments. [Ah yes, as did Keynesianism, but that break down was apparently short-lived.]
The committee generally recommended that the overall issuance of TIPS be increased over the next couple of years. For FY2010, TIPS issuance should be increased from the current run rate of $58 billion per year to an overall issuance amount of between $70 and $80 billion per year across securities. In FY2011, overall TIPS issuance should be further increased to between $100 and $125 billion.
A majority of TBAC members generally believed that despite legitimate concerns surrounding TIPS costs and liquidity, given its funding requirements Treasury would need to increase the size of the TIPS program. In addition, TIPS could help Treasury in its stated goal of extending the average length.
In terms of TIPS issuance, there was general consensus by committee members to eliminate the 20-year TIPS and replace it with 30-year TIPS issuance. This change might allow Treasury to capture a greater inflation-risk premium and would also create a TIPS issue that could be better compared to a comparable on-the-run nominal issuance point. The additional duration associated with a 30 year TIPS would also be consistent with Treasury's desire to increase average maturity.
And there you have it. Naked short sell inflation to collect premiums today (how about those positive externalities?) and lengthen the portfolio duration to buy as much time as possible ahead of the day of reckoning. Take note, bondholders, if you have not already.
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Seems to me that the only two forms of debt that the Fed
will be able to issue are 90 day bills and Tips....
Who in their right mind would make large commitments to
5,7,10 or 30 year debt ?
The Fed will buy long-term as they have been doing for some time now, though the Fed will do this via their retail partners like JPM and perhaps use some off shore entities. Of course the Fed will never admit they are the real buyers.
Call it QUEasing 2.0