A year and a half ago (The Bond Buyer, May 24, 1993), we objected to the Clinton Administration's proposal to shorten the maturity of U.S. Treasury debt. The Treasury Department plunged forward with that initiative in the summer of 1993.
Since then, long-term U.S. dollar-denominated bond investors have suffered enormous losses in the bond market sell-off that commenced in October 1993. This bond bear market has been widely attributed to inflation fears or Fed policy or dollar weakness. That roster of villains must also include the Treasury's policy shift to shorter maturities.
When the Treasury announced its new debt management approach, some observers believed that scarcity from reduced issuance of long-term Treasury bonds would increase their relative price. They were wrong.
The most dramatic change in the market value of U.S. government debt is evident in the longest-duration security. In theory, the 30-year Treasury strip (zero coupon) should function as a staple for risk-averse, long-term investors. In October 1993, the 30-year strip was priced at 20 to yield 5 1/2%; in November 1994, the same security was priced near 10 to yield above 8%, a loss of nearly half its value.
Witness how "on-the-run" Treasurys have compared with their predecessors. Recently, when the 30-year "on-the-run" Treasury yielded 8.15%, the previous "on-the-run," now "off-the-run," 30-year yielded 8.3%. These are wide disparities in pricing for a benchmark.
Greater price volatility, a classic indication of growing ownership risk, has tarnished long Treasurys since the new Treasury debt policy unfolded. During last July's Humphrey-Hawkins testimony, Fed chairman Alan Greenspan admitted, "We know from options data the degree of volatility in the financial markets is still somewhat higher than it was." Some analysts suggest this is due to "stripping" as well as diminished supply from reduced issuance.
Maybe. But higher volatility can also result from a market requirement for an additional and enduring risk premium because of our government's new debt management scheme.
The Treasury's present approach shifts about $6 billion a month of existing debt from long to short term. About $11 billion of 30-year bonds are now auctioned semiannually instead of quarterly. The 10-year note quarterly auctions have been stabilized at $12 billion; seven-year note auctions were discontinued; the five-year note auctions remain at a monthly $11 billion; two- and three-year note auction sizes have been held nearly constant.
Almost all incremental Treasury finance is now concentrated in three-, six-, and 12-month bills.
Accelerating issuance of Treasury bills must hamper Federal Reserve policy implementation. The market's internal dynamics combine the present targeted federal funds rate with the market's expectation of a future federal funds rate; this combination is the major determinant of Treasury bill rates.
Treasury bills are the nearest thing to cash; essentially, they function as interest-bearing cash. By increasing the bills' issuance, the federal government forces the markets to absorb burgeoning amounts of this alternative form of high-powered money.
When the Federal Reserve conducts open market operations in Treasury bills, it buys or sells the security with the highest incremental new issuance in the world. Although it targets the Fed Funds rate, the Fed knows that high-powered money creation results from each of its Treasury bill purchases.
But the Fed cannot yet know the high-powered money multiplier resulting from accelerating Treasury bill issuance. It doesn't have enough historical data; it can only guess.
Last year, we calculated the forward rates derived from the market's own internal forecasting mechanism. At that time, market expectations projected a one-year Treasury bill yield of 6% and higher commensurate rates throughout the yield curve.
All those forecasted rates have been exceeded. Today, forward rate techniques project a one-year Treasury bill yield of 8% by 1996.
Treasury officials and White House economic advisers claimed market validation of U.S. policy by repeatedly highlighting the bond market as long-term interest rates fell below 7%. Now officials like Treasury undersecretary Lawrence Summers or Robert Rubin, Clinton's nominee for Treasury secretary, omit this theme from their public comments.
The Treasury's maturity-change proposal appeared in the budget resolution offered last year by then Senate Budget Committee chairman James Sasser, D-Tenn. The Democratic Party Study Group sponsored the initial analysis.
The Treasury has never fully revealed the economic and intellectual rationale to support its policy shift. At one point, Treasury officials refused to release their documentation supporting the maturity structure changes. Moreover, when the Treasury adopted the proposal it ignored the advice of its own advisory panel, the Treasury Borrowing Committee of the Public Securities Association.
A May 1993 Congressional Budget Office study entitled "Federal Debt and Interest Costs" claimed that "a shift to short-term financing would raise the budget's sensitivity to interest rates and contains no guarantee of savings." The markets have upheld this assessment. Interest rates have risen so quickly that they call into question the savings that Treasury officials projected last year.
In recent midterm elections, the voting public has offered its general view of the last two years of federal governance. Financial market players have recorded their votes in the sell-off in bonds and the decline of the nation's currency.
The incoming Congress can redress last year's flawed action. It should convene hearings on Treasury debt management policies. But managing debt issuance requires an accurate compilation of the federal liabilities that the Treasury must finance. Congressional inquiry should also examine these liabilities on both a cash and an accrual basis.
The policy of "rolling" Treasury bills to finance infinitely long- term liabilities must be decisively reversed.
The global evidence is clear: Governments that issue longer-term debt are those that honor the store-of-value component in their currency. They, like Germany or Japan, try to provide reliable and consistent economic policies that encourage domestic and international confidence.
Governments, like Italy, that borrow greater and greater proportions of their income using shorter and shorter maturities suffer loss of international confidence, higher inflation, and deteriorating currencies.
A year and a half ago we asked if it was wise for our country "to emulate a hard currency policy or a soft one." We questioned which country's bonds you would buy if you were a global investor. Americans who bought their own bonds have lost the most.
