Previewing Tomorrow's Floating Rate Treasury Launch
When we last discussed what now appears certain to be a TBAC announcement tomorrow that Floating Rate Treasurys are about to be launched by the US during the Treasury, we cautioned, using an analysis by the IMF's Singh, that "the US Treasury may be telegraphing to the world that it, or far more importantly, the TBAC, is quietly preparing for a surge in interest rates." We then continued that "What is also obvious is that if the TBAC is quietly shifting the market into preparation mode for "a steady (or rocky) rise in rates from near zero to a "neutral" fed funds rate of 400 bps and a "normal" 5 percent yield on 2 year U.S. Treasuries" as the IMF warns, then all hell is about to break loose in stocks, as by now everyone is aware that without the Fed liquidity, and not just liquidity, but "flow" or constant injection of liquidity, as opposed to merely "stock", VIX will explode, equities will implode, and all hell would break loose. It is not yet certain if the TBAC will proceed with implementing FRNs. Although, since the proposal came from the TBAC, read Goldman and JPM, and what Goldman and JPM want, they get, it is almost certain that in about a month, concurrent with the next quarterly refunding, America will slowly but surely proceed with adopting Floaters." Judging by the amount of press coverage this topic has received in the past week, the advent of FRNs is now a given. What is unclear is why: our take is that this is simply a move to make Treasurys more palatable to investors, simply to avoid capital losses when rates finally resume their inevitable surge higher. The flipside of course, is that the guaranteed coupon payments in a rising rate environment means that more cash will leave the Treasury to cover interest. It is this corollary to increasing demand that has made the "father" of Treasury floaters warn on Bloomberg that now is the worst possible time to being sales of FRN Treasurys.
Almost two decades after advising the U.S. to sell floating-rate notes to lower debt expenses, Campbell Harvey says starting to issue the securities now would be a costly mistake for American taxpayers.
“In an environment with historically low interest rates, the Treasury should avoid floating-rate debt as it introduces risk,” Harvey, a finance professor at Duke University’s Fuqua School of Business in Durham, North Carolina, said in a telephone interview April 17. “If interest rates go up, it puts the government at risk because they will need to come up with a lot of extra revenue to pay the interest bill.”
To those who were confused by our explanation for the logic of FRNs, here it is again:
Floaters would increase the link between the government’s interest payments and movements in short-term rates, which have been near zero since 2008. The Treasury has sought to lock in borrowing costs for longer and cut the amount of outstanding short-term bills, which ballooned to $2.1 trillion during the financial crisis that began almost five years ago.
The securities may appeal to investors wary that four years of Federal Reserve monetary stimulus will spark inflation and cause the central bank to lift short-term rates even though policy makers have promised to keep borrowing costs near zero through 2014.
In other words, the cash outflow risk is increasing to taxpayers, but all that matters is that Primary Dealers, who as we noted recently are already loaded to the gills with short-term paper, will get some protection if and when short-term rates spiral out of control. Which is why thise whole process was initiatied and will be consummated under the auspices of the TBAC, which is basically Goldman and JPMorgan as we explained many times in the past, or in other words, the two main banks who buy USTs and then promptly flip them in the custodial repo market, allowing smooth and seamless bond auctions to take place in perpetuity, yet also getting cash for the paper within minutes of an auction's end.
It is precisely the bonds that PDs have an overabundance of, those with a 1-3 year maturity, that will be most impacted by this transition:
The floaters will probably have a maturity of one- to three-years initially, according to Bank of America Corp. The coupon would reset periodically based on a short-term benchmark, such as the federal funds effective rate, or the Depository Trust & Clearing Corp.’s Treasury overnight repurchase agreement index. Payments to investors would be similar to those of U.S. Treasury bills, while also increasing along with rates.
Some thoughts via Bank of America:
“The Treasury can, with floaters, lock in debt at a short- term rate without having to come back in the market as often as they have to do for bills,” said Priya Misra, head of U.S. rates strategy at Bank of America in New York, in an April 10 interview. Rising rates “are a risk to the Treasury relative to them issuing long-term coupon bonds, but not relative to them issuing Treasury bills,” she said.
Misra favors initial monthly auctions of about $10 billion in floaters, which may displace some bills. The Treasury sells bills with maturities of four, 13, 26 and 52 weeks.
Floaters will appeal to the $2.6 trillion U.S. money market mutual fund industry, TBAC said in a Feb. 1 presentation to the Treasury. Boston-based Fidelity Investments, the largest manager of money-market mutual funds, and Federated Investors Inc., of Pittsburgh, the third-biggest, supported the new debt during a public comment period that ended earlier this month.
The WSJ chimes in:
Analysts say the Treasury is betting that issuing floating-rate notes can help Uncle Sam pay a bill-like yield, but lock up the money it borrowed for a longer period than a few months.
"The Treasury is trying to avoid issuing more Treasury bills," said Joseph Abate, money-market strategist at Barclays. "And this would be potentially one way of doing that."
Still, the program would take some time to have a meaningful impact. Bank of America Merrill Lynch analysts estimate that the Treasury would start any floating-rate program by issuing around $10 billion in floating- rate notes each month. That compares to the roughly $400 billion in bills the Treasury issues each month.
Analysts expect demand for such short-term, high-quality floating-rate debt to be strong. New regulations that came in the wake of the financial crisis pushed financial institutions to hold more safe assets such as Treasurys, and floating-rate notes might be more attractive when interest rates eventually begin to rise.
Naturally, what this will do is push even more end holdings into the short-end of the curve, with the Fed now virtually all alone in possession of long-duration paper. However, unlike before when a dramatic spike up in rates would lead to principal wipe outs for short-maturity holders, for now they will at least get the protection of getting cash coupons based on a Libor margin, in the process stimulating demand.
Or that is at least the superficial explanation.
What is far more likely the true end goal, is for the TBAC to telegraph to the market that since FRNs are being adopted, that higher rates are coming, and in turn to push even more fixed income holders out of bonds of any variety (recall that FRNs will still have very modest cash returns at least initially), and into risky assets. Because the ponzi, like any true shark, has to keep swimming - in other words, the flow has to continue, much to the chagrin of all those who say that stock is what matters.
Will they succeed? It is unclear - what is clear is that the central planning regime has so far succeeded in only one thing - keeping stocks high by diluting paper, and creating a creaking damn wall of potential future inflation if and when the money in mattresses and savings accounts is released. As for any benefits for the real economy? None. But that would naturally entail deleveraging, or as it is called in Europe, austerity. And that is one thing America simply can not afford. Which is why it will instead plough on with the FRN plan, and we are absolutely certain that tomorrow we will get the introduction of the first new Treasury security since TIPS came on the scene back in 1997.
Bottom line: in order to appease the banks, the Treasury is once again taking on even more interest rate risk, where the ultimate loser will be the US taxpayer if and when rates rise, while the winners will the banks and the Primary Dealers. However since the US taxpaying public is already neck deep in its contingent commitments to keeping the banking sector viable that in the grand scheme of things allowing FRNs to be auctioned off is probably not all that much of an incremental sunk cost.
Finally, here is the Floater pitch book presented at the February Refunding announcement by the TBAC: