Some market participants have begun questioning why the US Treasury did not issue more longer-term debt to ‘lock in’ its financing at lower borrowing costs. This topic has been debated with particular fervour of late as large portions of the US economy, such as consumers and the corporate treasurers, have somewhat immunised themselves to higher rates via 30-year mortgages or terming out their corporate debt issuance. However, thinking of the Treasury department as a corporate or household debt manager is a deeply flawed comparison.
The Treasury seeks to finance the government’s debt at the lowest cost over time. It achieves this through a regular and predictable issuance pattern that was first pioneered by Paul Volcker when he served as under secretary in the 1970s. The Treasury concluded that, by being regular and predictable, it could, over time, harvest a liquidity premium that would benefit the taxpayer via lower issuance costs relative to the phases of the interest rate cycle.
But there are other, secondary goals of the Treasury’s issuance strategy, as the most recent Inter-Agency Working Group on Treasury Markets report notes:
‘The authorities aim for the Treasury market to support the broader financial system. The market does so by serving as a source of safe and liquid assets that support the efficient, stable flow of capital and credit to households and businesses, and by establishing a benchmark credit risk-free yield curve… The Federal Reserve implements monetary policy partly through transactions in the Treasury market. More broadly, the smooth operation of the Treasury market is important to the transmission of the stance of monetary policy to broader financial conditions and the US economy.’
However, for the sake of argument, let’s say the Treasury decided to discard the above guidance and instead chose to model the strategy of corporate issuers to ‘lock in’ borrowing costs by pivoting to increased longer-term debt issuance. There are several adverse consequences of this action.
Implications for the financial system
First, the Treasury would betray a critical role that it fulfills in markets as one of the world’s largest issuers – providing a public good. The Treasury’s functions are intimately tied to the dollar’s role as a reserve currency. It is simply not possible to have a reserve currency without a massive supply of short-duration fixed income securities that carry no credit risk. Imagine enjoying the benefits of a reserve currency but without a safe, liquid, low volatility market in which to invest that currency.
This is where the critical importance of Treasury bills, floating rate notes and shorter maturity coupon issues come into play in a way that longer-duration instruments cannot. These low volatility and liquid securities are important for any internationalised currency but are absolutely required for the world’s reserve currency. They have become even more important in a Dodd-Frank world of more stringent financial market regulation.
Second, for the Treasury to transition the bulk of its issuance primarily to the long end of the yield curve would be self-defeating since it would most likely destabilise fixed income markets. Why? The demand for long end duration simply does not amount to trillions of dollars each year. This is a key reason why the Treasury decided not to issue ultralong bonds at the 50-year or 100-year maturities. Simply put, it did not expect deep continued investor demand at these points on the curve to fit within its framework as a regular and predictable issuer.
In short, if the Treasury embarked on this ‘locking in’ strategy, it could destabilise interest rate markets, all the while starving those markets of the shorter-duration paper that is critical to the functioning of modern capital markets.
Third, there is some amusement in thinking that the Treasury could change its issuance tactically, with the agility of a corporate treasurer, and have an actual impact on the term structure of its liability portfolio. The Treasury has well over $23tn of marketable debt. Typically, in a given year, anywhere from 28% to 40% of that debt comes due.
Given the constraints on the amount of demand at the long end of the curve and adhering to a regular and predictable mantra so as not to disturb broader market functioning, it would take the Treasury years to noticeably shift its weighted average maturity even longer. More importantly, that may not protect against market price volatility (see the UK’s experience). By forcing substantial amounts of duration onto the market, it might be an active contributor in destabilising its own market. Moreover, if the Treasury had decided to dump duration into the market as the Fed was buying, it would be working at cross purposes with monetary policy.
Finally, the Treasury does not face rollover risk like private sector issuers. The rollover risk it does face tends to be more operational, such as during super storm Sandy in 2012 when there were concerns that auctions could not take place because dealers were physically unable to participate. A well-functioning Treasury market is a requirement for the execution of monetary policy, so the Treasury market cannot face rollover risk if the central bank wants to use the government securities market as a transmission mechanism for monetary policy. The concept of ‘locking in’ financing is more akin to tactical cost estimates rather than risk management around terming out debt.
The Treasury acting like an issuer tactically taking advantage of what it perceives to be low interest rates is not helpful to either its mandate or Treasury market functioning. Doing so would jeopardise the stability of a market critical to capital markets, the implementation of monetary policy and possibly the accessibility of the dollar as a reserve currency. One should be very wary of calling on the department to change its issuance strategy.
Amar Reganti is a Managing Director and Fixed Income Strategist at Wellington Management and former Deputy Director of the Office of Debt Management, US Treasury.
These themes will be further explored in ‘Rising Treasury yields: exploring the impact on markets’ on Thursday 30 November. Register to attend here.