FROM THE OFFICE OF PUBLIC AFFAIRS

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Dear Mr. Secretary:

Since the Committee’s last meeting on July 30th, the economic recovery appears to have slowed despite the recent rally in the equity markets.  Outside of the robust housing sector, economic indicators are showing signs of weakness.  Payroll growth remains far below what is generally considered necessary to absorb new entrants into the labor market.  Consumer spending shows signs of slowing and confidence indicators have all moved sharply lower.  Additionally, the impact of 0% financing seems to be waning as it brings fewer buyers into automobile dealer show rooms.  Inventory and equipment investment have picked up modestly, but are being more than offset by a continuing drop in nonresidential construction.  Most economists agree that the risks to continued growth are increasing although there remains considerable differences as to what, if anything, should be done to further stimulate the economy.  Meanwhile, productivity growth remains healthy and inflation indicators restrained with annualized core inflation growing at a 2.0% pace and the breakeven inflation rate for 10-year TIIS falling to 1.84.

After our last meeting, interest rates continued to fall, reaching historical lows.  However, rates have since rebounded and now stand only fractionally lower than they were at our last meeting.  Weakness in the equity market and market expectations of additional rate cuts from the Federal Reserve pushed the 2-year yield below the Fed funds target rate for several days.  2-year currently yields 1.77%.  Meanwhile, 10-year yields reached a low of 3.57% on October 9th.  Since then, rates have moved higher and the 10-year note yield now stands at 3.94%.

The overall high grade credit market basis widened 21 basis points since July 31 although spreads have tightened about 10 basis points since the October 9 spread peak.  Despite the recent improvement, relative corporate bond valuations are still at their widest levels in recent memory.  New issuance levels through October are down roughly 32% from last year as many borrowers either do not have market access or can only borrow at unattractive levels.  Lingering corporate management credibility concerns, along with negative rating agency actions, uncertain equity markets, pension under-funding, and portfolio concentration issues are all weighing on market sentiment, causing unprecedented spread volatility.

While most major indices are down just fractionally since our last meeting, equity markets continue to exhibit signs of fragility, including high levels of volatility.  The S&P 500 index is now off just 1.4% but was, at its inter-meeting lows, off nearly 14.0%.  Meanwhile, the VIX index, a measure of volatility, has remained elevated and, at its inter-meeting peak, reached levels just below those seen late last July.

The U.S. recorded a slightly better-than-expected $159 billion budget deficit for FY2002.  Meanwhile, budget deficit estimates for FY2003 reflect the continued uncertainty regarding the true cost of both the war on terror and the lingering effects of the equity market downturn.  At present, most budget deficit estimates for FY2003 now run between $175 billion and $250 billion, $25 billion to $50 billion higher than at the time of our last meeting, with few forecasters expecting a quick return to surpluses.

Against this economic backdrop, the Committee began consideration of various debt management questions from Treasury including the composition of 5- and 10-year notes to refund $2.8 billion of privately held bonds maturing on November 15 and the composition of Treasury marketable financing for the October-December and January-March quarters.

The first question posed by Treasury references the Administration’s Mid Session Review of the Budget that showed a deficit for FY 2002 of $165 billion, and forecasts deficits for FY2003 and FY2004, compared to originally projected significant surpluses in the FY2002 Budget.  As the change in fiscal position progressed, the Treasury suspended its scheduled reopening policy and increased auction sizes.  Given that projected outlook, Treasury asked for the Committee’s recommendations regarding potential additional adjustments to its financing plans for FY2003 and FY2004. 

The Committee recommended at its January 2002 meeting, and reiterated today, a sensible order for instituting changes to Treasury issuance policy.  That order of priority would be as follows:

• Issuance size
• Reopening policy
• Frequency of issuance
• Types of securities and maturities

The Committee also noted that Treasury had already addressed recent borrowing needs by increasing issuance size and ending automatic reopening policies for both the 5-year and 10-year notes. 

To specifically address the FY2003 and FY2004 plans, the Committee stressed that the first significant maturity of large two-year notes occurs in August 2003.  Prior work by this Committee indicates an increase in issuance would not be needed until at least November 2003.  In summation, there was consensus that few changes were needed until Q4 2003, and those could be handled with an increase in size and/or frequency of issuance in the 5-year or 10-year note sectors.  Further information was needed to plan for FY2004. 

The Committee also discussed average maturity of the debt which has contracted sharply over the past 18 months from 6 years 4 months to 5 years 6 months, leading to concentration risk in securities of less than two years.  Given current robust market conditions for fixed-income securities, the Committee felt the environment was appropriate for lengthening maturities and redistributing issuance to alleviate this concern.

One final suggestion made by a member of the Committee, and broadly endorsed by others, was to communicate future issuance changes early to the markets.  A minimum of a 3-month warning to investors regarding changes was suggested.

The Treasury’s second question asked the Committee to define measures of debt management that might provide useful indicators of the quality of debt management decisions.  While most members felt Treasury could use any number of indicators to accomplish their goals, they also noted that market and economic conditions might dictate which should be used at any particular point in time.  For instance, in normal market conditions, the spread of Treasuries to Libor might be a valuable barometer of Treasury’s effectiveness while during other market conditions, where the market was substantially more volatile, it might not.  Additionally, some members felt that given Treasury’s role as a non-opportunistic borrower, broad criteria used to judge its performance might be of little use.

Ultimately, the Committee agreed that the following measures, in no specific order, might prove useful to Treasury in judging the quality of its debt management decisions:

1. Accuracy around budget forecasting
2. Market volatility at the time of Treasury borrowing announcements
3. Auction statistics (bid to cover ratios, auction tails, time between bid submission cutoff and auction result announcements)
4. Relative pricing of Treasury securities against either Libor or a fitted curve
5. Treasury volumes and turnover
6. Treasury market structure vs. other G10 government markets
7. Financing issues such as the size and duration of fails to deliver and receive

In closing, most Committee members agreed that it would be beneficial to revisit the question at a later date, after having prepared for a more specific discussion of the potential alternatives available to Treasury.

The third question asked for recommendations regarding the size and frequency of  Treasury Inflation-Indexed Securities (TIIS) issuance in order to promote growth of the overall program.  In response the Committee noted that investor interest had continued to grow in recent months at least partly due to repeated statements of support by Treasury for the program.  Most members felt that a similar statement should accompany any plans to grow issuance or otherwise expand the program further.

In terms of frequency of issuance several members suggested that one new issue per annum with three subsequent reopenings would be effective in growing the product, as market liquidity would build throughout the year in the same current issue.  The majority, however, thought that two new issues and two reopenings per year would prove most effective as it would accomplish Treasury’s objectives without the maturity bunching caused by a single annual issue. 

In considering the potential size of annual issuance for TIIS, the Committee noted that TIIS, while still relatively cheap, had been gradually richening to nominal securities and that a cautious approach to increasing overall issuance size was warranted to grow the product consistent with underlying demand.  As a result, a target issuance range for 2003 of $23-$30 billion was appropriate.

The Committee then turned to the question involving the composition of five- and ten-year notes to refund $2.8 billion of privately held notes maturing November 15th, composition of Treasury marketable financing for the remainder of the October-December quarter including cash management bills if necessary, and composition of the marketable financing for the January-March quarter. 

The Committee recommends $22 billion 5-year notes due November 15, 2007 and $18 billion ten-year notes due November 15, 2012.  For the remainder of the quarter, the Committee recommends two $27 billion 2-year notes to be auctioned November 27 and December 23 as shown on the attached table.  The Committee does not recommend any cash management bills through the end of the quarter.

For the January-March quarter, the Committee recommended financing as contained in the attached table.  Relevant features include three $27 billion 2-year notes, one $22 billion 5-year note, and one $18 billion 10-year note--all similar in size to the previous quarter.  The Committee further recommended a $7 billion reopening of Treasury Inflation-Indexed Securities due July 10, 2012, which follows Treasury’s previous guidance regarding TIIS issuance.  In this quarter no cash management bills are recommended.

Respectfully submitted,
Timothy Jay
Chairman

Mark Werner
Vice Chairman

Related Documents:

• Financing Table Q4 2002
• Financing Table Q1 2003