Presentation to the Treasury Borrowing Advisory Committee
U.S. Department of the Treasury Office o f De bt M anagement November 3, 2009 Federal Budget Deficits FY2007 to FY2009
Fiscal Year to Date Deficits $ Billions (monthly data) -1,600 600% 2007 Y-O-Y % Change 2008 2009 -1,417 -1,400 -1,378 500% -1,267
-1,200 -1,086 400% -992 -1,000 -957 300% -765 -802 -800
200% -569 -600 -483 -485 -455 -371 -402 100% -400 -311 -319 -274 -269 -258 -263 -237 -148 -163 0% -200 -162 -157 -152 -81 -121 -154 -122 -42 -106-88 -49 -80 -56 0 -100% Jul-07 Jul-08 Jul-09 Oct-06 Oct-07 Oct-08 Apr-07 Apr-08 Apr-09 Jan-07 Jun-07 Jan-08 Jun-08 Jan-09 Jun-09 Feb-07 Mar-07 Feb-08 Mar-08 Feb-09 Mar-09 Nov-06 Aug-07 Sep-07 Nov-07 Aug-08 Sep-08 Nov-08 Aug-09 Sep-09 Dec-06 Dec-07 Dec-08 May-07 May-08 May-09
Office of Debt Management 2 Federal Outlays and Receipts
OtlOutlays 1-Oct 15-Nov 31-Dec 15-Feb 1-Apr 17-May 2-Jul 16-Aug 0 FY07 FY08 FY09
-500
-1,000
-1,500
$ Billion -2,000
-2,500
-3,000 Outlays were up $558 B YoY
-3,500 Receipts
3,000
FY07 FY08 FY09 2,500 Receipts were down $413 B YoY 2,000
$ Billion 1,500
1,000
500 Source: DTS
DTS numbers are 0 approximate and Office of Debt Management may not match MTS. 1-Oct 15-Nov 31-Dec 15-Feb 1-Apr 17-May 2-Jul 16-Aug 3 Tax Receipts Continue to Decline
Rolling 12-Month Growth Rates
40% Corp Taxes WH Taxes 30% nWH Taxes
20%
10%
0%
-10% WH taxes down $108 B YoY, or 11 %
-20%
-30% nWH taxes down $143 B YoY, or 31% Corp taxes down $128 B -40% YoY, or 36%
-50% Mar-82 Mar-83 Mar-84 Mar-85 Mar-86 Mar-87 Mar-88 Mar-89 Mar-90 Mar-91 Mar-92 Mar-93 Mar-94 Mar-95 Mar-96 Mar-97 Mar-98 Mar-99 Mar-00 Mar-01 Mar-02 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Office of Debt Management 4 Treasury Marketable Financing in FY2008 and FY2009
Treasury Marketable Financing FY 2009 FY 2008 ($ Billions) October 1, 2008 - September 30, 2009 October 1, 2007 - September 30, 2008
Net SOMA Net Cash Net SOMA Net Cash Issued Matured Activity * Raised Issued Matured Activity * Raised Bills (includes SFPs) $6,920.5 $6,417.8 $0.0 $502.7 $4,632.9 $4,101.2 ($152.0) $531.7
Nominal coupons $1,886.6 $640.7 $0.0 $1,245.9 $814.6 $626.2 ($5.5) $188.5
TIPS $58.5 $20.8 $0.0 $37.7 $61.9 $21.8 $3.5 $40.1
Total $8,865.6 $7,079.3 $0.0 $1,786.3 $5,509.5 $4,749.2 ($153.9) $760.4
* Note: Negative SOMA activity represents redemptions. Positive SOMA activity represents additional issuance of securities, made possible by redemptions in maturing securities with the same settlement date; these are offsetting transactions and are net cash neutral.
Office of Debt Management 5 Cumulative Net Financing Flows since FY2007
SFP Amounts CMBs RegBills TIPS Notes Bonds Net Mktable Borrowing $ Billions $3,000
$2,500
$2,000
$1,500
$1,000
$500
$0 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 FY 2007 FY 2008 FY 2009 -$500
Office of Debt Management 6 Cumulative Net Coupon Issuance since FY 2007
400 1,600
2-year (LHS) 3-year (LHS) 350 1,400 5-year (LHS) 7-year (LHS) 300
10-year (LHS) 30-year (LHS) 1,200 250
Total (RHS) Billions) Billions) 200 1, 000
150 800 100 Net ($ Issuance Net ($ Issuance ee ee 50 600 Cumulativ Cumulativ 0 400
-50
200 -100
-150 0 Jul-09 Jul-08 Oct-08 Apr-09 Oct-07 Apr-08 Jun-09 Jun-08 Jan-09 Jan-08 Feb-09 Mar-09 Feb-08 Mar-08 Aug-09 Sep-09 Aug-08 Sep-08 Nov-08 Nov-07 Dec-08 Dec-07 May-09 May-08
Office of Debt Management 7 Treasury Cash Balances
Treasury Daily Operating Cash Balance $ Billions Excluding SFPs Note: Data through October 23, 2009 175 Dec. 15 Apr. 15 Jun. 15 FY 2007 FY 2008 Sep. 15 150 FY 2009 FY 2010 125
100
75
50
25
0 Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep $ Billions Daily Treasury Operating Cash Balances Note: Data through October 23, 2009 800 Cash Balance w/o SFPs Cash Balance w/SFP 700
600
500
400
300
200
100
0 Oct-08 Nov-08 Dec-08 Jan-09 Feb-09 Mar-09 Apr-09 May-09 Jun-09 Jul-09 Aug-09 Sep-09 Oct-09 Office of Debt Management 8 Portfolio Distribution
Nominal Coupons as a Share of Total Portfolio Bills as a Share of Total Portfolio 71% 37% 69% 35%
33% 67% All Bills Regular Bills 31% 65% 29% 63% 27%
25% 61%
23% 59% 21% 57% 19%
17% 55% Oct-04 Apr-05 Oct-05 Apr-06 Oct-06 Apr-07 Oct-07 Apr-08 Oct-08 Apr-09 Oct-09 Oct-04 Apr-05 Oct-05 Apr-06 Oct-06 Apr-07 Oct-07 Apr-08 Oct-08 Apr-09 Oct-09
TIPS as a Share of Total Portfolio Total Portfolio 13% 80%
12% 70%
11% 60%
10% 50% TIPS Nominal Coupons 9% 40% Standard Bills CMBs/SFPs 8% 30% 7% 20% 6% 10% 5% Oct-04 Apr-05 Oct-05 Apr-06 Oct-06 Apr-07 Oct-07 Apr-08 Oct-08 Apr-09 Oct-09 0% Oct-04 Apr-05 Oct-05 Apr-06 Oct-06 Apr-07 Oct-07 Apr-08 Oct-08 Apr-09 Oct-09 Office of Debt Management 9 Monthly Change in Debt Outstanding versus Average Maturity
$ Billions Average Maturity (Months) 600 60 Issuance of SFP bills begins Sept 2008 GSE Preferred Stock Purchase SFP bills peak at $560 B Nov 2008 Program begins Oct 2008 58 500 Capital Purchase Program $115 B dispersed Oct 2008 $36 B disbursed Nov 2008 56 400 54
300 Bulk of $168 B Stimulus 52 •Average Maturity Oct 2008: 48.5 months tax rebates disbursed Bills o/s: $1.9 T and Coupons o/s: $3.8 T May - Aug 2008 200 50 •Average Maturity Sept 2009: 52.7 months Bills o/s: $1.9 T and Coupons o/s: $5.0 T 48 100
46 0 44
$40 B -100 AIG Tax year 2008 42 Bills Coupons Average Maturity Investment refunds peak Nov 2008 Feb 2009
-200 40 88 88 88 99 99 99 99 99 99 99 99 77 77 77 77 77 77 77 77 77 77 88 88 88 88 88 88 88 88 99 77 77 88 Jul-0 Jul-0 Jul-0 Apr-0 Oct-0 Apr-0 Oct-0 Apr-0 Jan-0 Jun-0 Jan-0 Jun-0 Jan-0 Jun-0 Feb-0 Mar-0 Feb-0 Mar-0 Feb-0 Mar-0 Aug-0 Sep-0 Nov-0 Aug-0 Sep-0 Nov-0 Aug-0 Sep-0 Dec-0 Dec-0 May-0 May-0 May-0
Office of Debt Management 10 Debt Maturity Measures
Months Months
90 90 Average Maturity of Issuance 1/
80 80
70 70
60 60
50 50 Average Maturity of Marketable Debt Outstanding
40 40
30 30
1/ Rolling 4-quarter average
20 20 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 Office of Debt Management 11 Maturing Coupons
$ Billions November 15, 2009-August 15, 2039 *Based on coupon securities outstanding as of October 15, 2009 90 2 YR NOTE 3 YR NOTE 5 YR NOTE 10 YR NOTE 30 YR BOND 7 YR NOTE 5 YR IIS NOTE 10 YR IIS NOTE 20 YR IIS BOND 30 YR IIS BOND 80 In the next 5 years , 73 days will have maturities greater than $20 billion and 46 days greater than $30 billion. 70
60
50
40
30
20
10
0 15-JUL-2017 15-JUL-2018 15-JUL-2019 15-JUL-2013 15-FEB-2029 15-FEB-2036 15-FEB-2026 28-FEB-2014 30-JUN-2014 15-FEB-2012 15-FEB-2011 30-JUN-2011 Office15-FEB-2010 of Debt Management 15-MAY-2039 15-NOV-2027 15-MAY-2021 15-AUG-2023 15-NOV-2014 15-NOV-2015 15-MAY-2016 31-AUG-2016 15-NOV-2013 15-MAY-2012 15-AUG-2012 15-NOV-2012 15-NOV-2011 15-MAY-2010 15-AUG-2010 15-NOV-2010 15-NOV-2009 31-MAR-2013 12 Primary Dealer and Government Deficit Estimates
FY 2010 Deficit Estimates $ Billions Primary Dealers* CBO OMB Current: 1, 393 1, 381 1, 502 Range based on average absolute forecast error** 1,203-1,583 1,081-1,681 1,219-1,785 Estimates as of: Oct 09 Aug 09 Aug 09
FY 2010 Marketable Borrowing Range*** 1,200-1,750 FY 2011 Marketable Borrowinggg Range*** 725-1,400
* Primary Dealers reflect average estimate. Based on Primary Dealer feedback on October 29, 2009. ** Ranges based on errors from 2005-2009. *** Based on Primary Dealer feedback on October 29, 2009.
Office of Debt Management 13 OMB Long-term Deficit and Borrowing Projections
Debt as % of GDP OMB Interest Expense as % of GDP 8/09 OMB 30 140% 800 4.0% MSR 8/09 Held by Public (LHS) MSR 700 3.5% Held by Govt (LHS) 120% 25 600 3.0% Interest Expense as % of Gross Debt % of GDP (RHS) 100% 20 GDP (RHS) 500 2.5% 80% 15 400 2.0% $Billions 10-y Rolling-
$Trillions 60% 300 Avg (RHS) 1.5% 10 Held by Public% 40% 200 1.0% (RHS) 5 Interest Expense (LHS) Held by Govt Accts% (RHS) 20% 100 0.5%
0 0% 0 0.0% 1940 1944 1948 1952 1956 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 2008 2012 2016 1940 1944 1948 1952 1956 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 2008 2012 2016 Annual Surplus/Deficits OMB 400 4% Net Marketable Borrowing as % of GDP 8/09 Surplus/Deficits MSR 14% 2,000 200 (LHS) 2% OMB 8/09 12% 0 MSR 0% 10% 1,500 -200
-2% 8% -400 1,000 Net Marketable Borrowing as % of -600 -4% 6% Surplus/Deficits as a $Billions GDP (LHS) $ Billions -800 % of GDP (RHS) 4% -6% 500 2% -1,000 -8% -1, 200 0% 0 -10% -1,400 -2% Net Marketable Borrowing (RHS) -1,600 -12% -4% -500 Office of Debt Management 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 1950 1953 1956 1959 1962 1965 1968 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 2016 2019 14 Rescheduled 4-Week Bill Auctions Due to Calendar Constraints
Rescheduling of 4-Week Bill Auctions Due to Conflicts FY2008 - FY2009 2:00 PM
1:30 PM
1:00 PM lose Time 12:30 PM
Bill Auction C Bill Auction 12:00 PM In FY2009, the frequency with which 4-week auctions were rescheduled to 11:30 AM increased siggynificantly.
11:30 AM
7 auctions in FY2008 23 auctions in FY2009
11:00 AM Oct-07 Jan-08 Apr-08 Jul-08 Nov-08 Feb-09 May-09 Aug-09
Office of Debt Management 15 4-Week Bill Coverage Ratios and Offering Amounts
1:00 p.m. Close 11:30 a.m. Close 6.00
5505.50
5.00
4.50
4.00 ratio
3.50 rage ee
Cov 3.00
2.50
2.00
1.50
1001.00 0 5 10 15 20 25 30 35 40 45 Amount Offered (in Billions) Office of Debt Management 16 Potential Cost Saving of Moving to 30-Year TIPS
4.0
353.5
3.0 dd 2.5 Yiel
2.0
1.5
1.0 08 09 06 07 09 09 09 07 07 07 08 08 08 00 00 00 00 00 00 00 00 00 00 00 00 00 1/10/2 4/10/2 7/10/2 1/10/2 4/10/2 7/10/2 1/10/2 4/10/2 7/10/2 10/10/2 10/10/2 10/10/2 10/10/2
10yFwd10y zcis 20yFwd10y zcis Source: Barclays Live Graph shows 10-year and 20-year forward zero-coupon inflation levels for 10 years derived from Zero Coupon Inflation Swap data. Long-term inflation expectations are assumed to be stable; therefore, an upward sloping curve demonstrates an increasing inflation risk premium.
Office of Debt Management 17 What adjustments to debt issuance , if any, should Treasury make in consideration of its financing needs in the short, medium, and long term?
Office of Debt Management 18 TBAC Presentation to Treasury
November 3, 2009 TBAC Presentation to Treasury: Exit Strategies
November 3, 2009
2 Outline
•Importance of the Exit Strategy
•Form and likely Sequence •Removal of Excess Reserves •Ending the MBS purchase program •Raising the Funds rate target
•Implications for the Treasury and related markets
•Potential policy errors
•Conclusions/Recommendations Importance of the Exit Strategy
•Near zero interest rates have had a significant impact on investor demand for many asset classes
•Many investors can not stay in cash or earn zero for long •Pension funds •Insurance companies •Endowments •Retired individuals living on income
•Zero yields on money market funds have pushed investors into longer-dated riskier asset classes
•The return of low cost financing as repo markets have reopened (aided by TALF and other Fed programs) has pushed leveraged investors into longer-dated riskier assets classes
•The increased demand has benefited Treasuries somewhat, but has benefited risk assets such as corporate bonds and securitized assets even more
•When the markets anticipate the move away from zero, the impact on longer dated risk assets may be significant due to reduced investor demand Importance of the Exit Strategy
•Investors have been moving out of cash and into longer-dated risk assets as the markets have stabilized and cash earns zero
•This can be seen in mutual funds flows
$ billions Money Market Funds US Fixed Income Mutual Funds US Equity Mutual Funds 400 140 30
300 120 20 100 200 10 80 0 60 100 40 -10
0 20 -20 0 -100 -30 -20 -40 -40 -200 -60 -50
-300 -80 -60 Q108 Q208 Q308 Q408 Q109 Q209 Q309 Q108 Q208 Q308 Q408 Q109 Q209 Q309 Q108 Q208 Q308 Q408 Q109 Q209 Q309 Importance of the Exit Strategy
The sponsorship for longer dated risk assets has led to lower yields
% yield 7 25
6 20
5
15 4
3 10
2
10y r treasury 5 IG Corporates (Barclays Index) 1 Current coupon mortgage HY Corporates (Barclays Index) 10-yr Super Senior CMBS 0 0 Jun/2008 Sep/2008 Dec /2008 Mar/2009 Jun/2009 Sep/2009 Jun/2008 Sep/2008 Dec /2008 Mar/2009 Jun/2009 Sep/2009 Form and Likely Sequence of the Fed’s Exit Strategy
• The Fed has a very difficult task to get the form and timing correct • Importance of the first move • Uncertainty and fragility of the economic recovery • Dependence of housing and other sectors on low rates
• As a result, predicting the form and timing of the exit strategy is also difficult
• The most likely sequence appears to be 1. Draining excess reserves 2. Ending MBS purchases 3. Raising the Funds rate target Form and Likely Sequence: This Tightening Cycle is Different
$ billions 10% 1200
9% Funds rate target 1000 8% Reserve balances with the Federal Reserve Banks 7% 800 6%
5% 600
4% 400 3%
2% 200 1%
0% 0 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 Form and Likely Sequence: Excess reserves to neutralize Form and Likely Sequence: Alternatives for Neutralizing Reserves
•Raise the funds rate and thereby the rate paid on excess reserves •Increases opportunity cost of using reserves •Potential complication(s): requires Fed to raise the funds rate
•Reverse repurchase agreements •Banks and perhaps money markets potential counterparties •Changes composition of Fed’s liabilities •Potential complication(s): reverse repos for TSYs cleaner than for MBS, scope for draining reserves unclear
•Term deposits •Banks move overnight reserves into term facility •Potential complication(s): Mechanism for setting rate and bank utilization unclear, implications for LIBOR market
•Sell assets •Shrinks asset and liability sides of the balance sheet •Potential complication(s): Private appetite for additional MBS and Treasury securities unclear Form and Likely Sequence: Reverse Repos
•Direct with Dealers •Initial capacity $150 - $200 billion •Tier one capital relief could boost capacity in some instances •Unlimited term
•Direct with Money Market funds •Initial capacity near $1000 billion •Term less than 7 days •Requires cumbersome setup
•TALF Model •Banks are agents; allow access to MM with cumbersome setup •No incentive for Banks
Market implications •Compete with other short-term investments •Upward pressure on bill rates Form and Likely Sequence: balance sheets, reserves and treasury demand
Cumulative change in composition of bank assets $ billions 300
200 •Loans and leases declined from $7.3 trillion to $6.7 trillion over the past 100 year
0 •Declines are being partially offset by -100 securities purchases, particularly
-200 Treasuries
-300 •Reserves being moved to securities?
Securities in bank credit -400 Loans and leases in bank credit Cash assets -500
-600 Dec /2008 Feb/2009 A pr/2009 Jun/2009 A ug/2009
Change in securities from Dec 17th Treasuries and agencies 163.2 Other 65.7 Total 228.9 Form and Likely Sequence: Ending MBS Purchases
The Fed’s purchases of MBS have had a significant impact on valuations
MBS Spreads bps Fed Holdings as % of Total Outstanding by Coupon 250 100%
90% 200 80%
Libor OAS 70% 150 FNMA 30y fixed Zero vol spread 60% FGLMC 30y fixed
100 50%
40% 50 30%
0 20%
10%
-50 0% 2003 2004 2005 2006 2007 2008 2009 3.544.555.566.577.5 Form and Likely Sequence: Ending MBS Purchases
Housing market still fragile and needs low mortgages rates
House Prices 60 days+ Mortgage Delinquencies Gross MBS Issuance percent 20 45% $ billion 1,400 Jumbo Alt-A Subprime Other Home Equity 15 40% Non Agy Agy 1,200 10 35%
5 30% 1,000
0 25% Subprime 800 Alt-A -5 20% Option ARM 600 Prime jumbo -10 Case Shiller HPI, 15% All y/y 400 -15 10%
-20 5% 200
-25 0% 0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2004 2005 2006 2007 2008 2009 2005 2006 2007 2008 2009 Form and Likely Sequence: Raising the Fed Funds Rate
•Markets pricing in the first move in the first half of 2010 and expecting gradual tightening similar to the past
•Another possibility is a discreet initial move (to 1% for example) to remove emergency level followed by a pause and then gradual tightening
percent 6.0
5.0
4.0
3.0
2.0 Funds rate target Eurodollar curve 1.0
0.0 2005 2006 2007 2008 2009 2010 2011 2012 Market Implications: Net Fixed Income Supply
$ billions 3500
3000 Corporate and foreign bonds 2500 Municipals
2000 Agency/GSE-backed debt
1500 Treasury securities
1000 Open market paper
500 Total after Fed purchases
0 Total
-500
-1000
2003 2004 2005 2006 2007 2008 2009E 2010E Market Implications: Net Fixed Income Purchases
$ billions Market Implications: Concern about higher real rates rather than inflation?
5yr5yr Forward TIPS Inflation Expectations Volatility Skew (1y10yr 100 high vs. 100 low strike) percent bps 4.0 35
3.5 30
3.0 25
20 2.5 15 2.0 10 1.5 5 1.0 0
0.5 -5
0.0 -10 2005 2006 2007 2008 2009 2005 2006 2007 2008 2009 Market Implications: Issuance and debt outstanding
Quarterly Issuance Marketable Debt Outstanding 80% 70%
70% 60%
60% 50% Bills 50% Bonds 40% TIPS 40% 2 - 10yr 30% Bills 30% Bonds 20% 20% TIPS 2yr - 10yr 10% 10%
0% 0% 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 Market Implications: Average Maturity of the Debt
months percent 80 16
70 14
60 12
50 10
Average maturity of debt 40 projected 8 Core CPI, y/y (right) 10yr Treasury (right) 30 6
20 4
10 2
0 0 1980 1984 1988 1992 1996 2000 2004 2008 2012 2016 Market Implications: More TIPS Issuance
Advantages •Diversify and broaden the buyer base of Treasury debt in time of extreme borrowing need •Potentially further lower the funding cost of nominals if TIPS remove some inflation risk premium •Further extends average maturity of issuance and debt •Limited risk because tax receipts effectively hedge Treasury inflation exposure
Disadvantages •Given low breakevens, there is potential for higher explicit cost relative to nominal •If there is substantial further disinflation or deflation, buyer base for TIPS may dwindle just as issuance increases TIPS as Percentage of Nominals Outstanding
14%
12%
10%
8%
6%
4%
2%
0% 1997 1999 2001 2003 2005 2007 2009 Potential Policy Errors
Fiscal considerations •Lack of budgetary restraint •Big issue for non-US investors •Need spending cuts or tax revenue increases as economy stabilizes •Need to refrain from a second fiscal stimulus
Monetary considerations •Liquidity programs •Many of the programs addressing the money markets and financing can be removed now •TALF is still needed to restart the shadow banking system, particularly for more difficult assets •MBS program •Housing market still needs low rate •Stopping purchases vs. selling MBS •Traditional policy •Raising rates too soon is the bigger risk Conclusions
•The Fed’s exit strategy is a significant challenge and the form and timing will have a significant impact on the broad financial markets
•The likely first step will be the use of reverse repos to remove excess reserves from the banking system
•The eventual increase in the Fed funds rate target will have the biggest impact and will likely come at a time when supply of fixed income securities is increasing and the Fed has stopped purchasing longer-dated securities
•The Treasury should continue to have a very transparent plan to increase issuance given the growing deficit and •Extend average maturity •Issue more inflation-linked debt Treasury Borrowing Advisory Committee: Optimal Issuance Strategy
Quarterly Meeting November 3 , 2009 Questions
Given the recent trends in the economy and the government’s fiscal position, please discuss Treasury’s plan to lengthen the average maturity of the portfolio in the medium term. Is there an optimal average maturity range , given structural financing needs in the medium and long term? Does it make sense to apply asset-liability management to Treasury’s marketable debt portfolio? Can you discuss approaches to financing and risk management by other sovereign nations and how they might be applicable to the US Treasury debt management?
2 Agenda
♦ Background ♦ Optimization Model/Debt management strategies ♦ Conclusions: 1. Inflation , higher interest rate and roll over risk should be the primary concerns in Treasury’s debt management strategies. 2. In most scenarios, it is prudent to lengthen maturities significantly from current average maturity of 50 months . Our base case is to extend to 74 months , stretch case to extend to 96 months. 3. The objective of lowest borrowing cost could lead to higher yields that conflict with monetary policy objective . 4. Clever debt management strategy could potentially reduce debt service cost meaningfully, but still can’t completely substitute for prudent fiscal policy.
3 Comparison of debt management strategies across the G7
Debt managggement strategies across the G7 Av g Maturity % Foreign Total Public Ratio of Ratio of debt Interest Pay ments Debt Management Country (y ears) Ow nership Debt (USD $bn) Debt to rev enue to GDP as share of rev enue Methodology Summary USA 4.25 49% 7551** 359% 53% 18% Cashflow matching. No ALM framew ork currently used UK 14.2 30% 1,347.1 118% 56% 3.30% Cashflow matching. No ALM framew ork currently used Optimizes mix of funding instruments to minimize long term cost and risk for the issuer. Deriv ativ e instruments such as sw aps are also Germany 6.10 30%* 1522 151% 65.90% 6.10% used Cashflow management. Management of av erage maturity and effort France 6.70 30%* 1689.7 137% 67.40% 5.70% made to ensure liquidity in issues Strategic scenario analy sis and risks. Use of v arious cash and Italy 6.87 30%* 2382.5 230% 105.80% 11.10% deriv ativ es products to minimize cost of debt and reduce risk Japan 7.00 6% 9875.1 2331% 190% 26.20% Cashflow matching. No ALM framew ork currently used Australia 5.60 53% 92.87 19% 4.60% 2.60% Cost and risk optimization. Use of sw aps until Nov 2007 Driv en by set of principles to minimize risk and costs of debt and help the DMO issue debt cost-effecitv ely . Focus is on fiscal control, gov ernment balance sheet risk management, and containment of moral hazard, and limiting contingent liability risk to the Gov ernment. Contingent liabilities are disclosed, analy zed and contained on a sub- New Zealand 5.60 72% 35.8 49% 15.60% 6.00% national lev el w ith limited central gov ernment interv ention.
* Estimated ow nership for Eurozone debt by non Eurozone members ** Debt held by public
Sour ce: J P Mo rgan
4 Average maturity of outstanding treasuries is approximately 50 months, which is near 25-year lows!
Average Maturity of Outstanding Treasuries, Months
75 30-year bonds were eliminated, issuance was Treasury added a 20-y ear reduced, and buybacks occurred, reducing the maturity point and increased average maturity 70 sizes across the curve
65
60
55 Substantial unexpected funding needs prompted high amounts of bill 50 issuance, further reducing av erage maturity
45 Dec-80 Sep-86 May-92 Feb-98 Oct-03 Jun-09
Sour ce: J P Mo rgan
5 Total federal government debt to GDP ratio was only higher during WW II
Source: Bianco Research
6 Debt to GDP about to go up significantly
Source: White House Office of Management and Budget, Congressional Budget Office
7 Mandatory spending has increased 5x faster than discretionary spending
Source: The Heritage Foundation 2009 Federal Revenue and Spending Book of Charts; and White House office of MdBdManagement and Budget
8 Entitlement spending is confronting a demographic time bomb
Source: The heritage Foundation 2009 Federal Revenue and Spending Book of Charts; and Congressional Budget Office
9 Plausible budget deficit outlook
2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 CBO August Baseline -1587 -1381 -921 -590 -538 -558 -558 -620 -625 -622 -722
Plausible Revenue Changes EGTRRA & JGTRAA 0 -4 -121 -217 -247 -260 -271 -281 -290 -298 -307 AMT 0 -7 -69 -31 -34 -37 -41 -46 -53 -60 -70 Interaction 0 0 -13 -44 -49 -53 -58 -64 -70 -77 -85 Making Work Pay, etc. 0 -48 -141 -199 -203 -201 -199 -198 -199 -202 -205 High Income 0 76 106 131 140 147 155 165 175 186 186 Debt Service 0 0 -4 -17 -42 -75 -109 -146 -189 -236 -286 Subtotal Rev 0 17 -242 -377 -435 -479 -523 -570 -626 -687 -767
Plausible Spending Changes Inflate Discretionary by GDP 0 -8 -33 -74 -120 -159 -194 -228 -261 -294 -328 Iraq War Phaseout 0 1 7 29 59 83 97 104 106 111 115 Debt Service 0 0-1-1-3-8-13-19-28-39-52 Subtotal Disc. Spending 0 -7 -27 -46 -64 -84 -110 -143 -183 -222 -265 Total Change 0 10 -269 -423 -499 -563 -633 -713 -809 -909 -1032
Resulting Surplus / Deficit -1587 -1371 -1190 -1013 -1037 -1121 -1191 -1333 -1434 -1531 -1754 GDP 14140 14439 14993 15754 16598 17319 18019 18760 19524 20308 21114 DfiitDeficits as % of GDP -11. 2% -95%9.5% -79%7.9% -64%6.4% -62%6.2% -65%6.5% -66%6.6% -71%7.1% -73%7.3% -75%7.5% -83%8.3% Debt Held by Public 7612 8984 10174 11186 12224 13345 14536 15869 17304 18836 20590 Debt / GDP 54% 62% 68% 71% 74% 77% 81% 85% 89% 93% 98% Interest 177 199 250 319 420 556 657 746 841 934 1038 Interest Rate 2.3% 2.2% 2.5% 2.9% 3.4% 4.2% 4.5% 4.7% 4.9% 5.0% 5.0%
Source: Concord Coalition, CBO, JCT, The Lindsey Group 10 The federal budget has benefited from the decline in rates, BUT approximately 40% of marketable Treasury securities now mature in less than 1 year
Interest payments on federal debt
18% 16% 14% 12% 10% 8% 6% 4% 2% 0% 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009
Net interest as % of federal budget Average interest paid
Source: Economic Report of the President 2009
11 Interest payments to rise substantially
Source: Heritage Special Report July 27, 2009; Office of Management and Budget, Budget of the United States Government, FY 2010, Historical Table, Table 3.2, (July 15, 2009); Congressional Budget Office, A Preliminary Analysis of the President’s Budget and an Update of CBO’s Budget and Economic Outllook, March 2009, (July 15, 2009). Figures adjusted for inflation into 2009 dollars.
12 Large fiscal expansions coupled with debt monetization lead to inflation
Sour ce: Deutsche Bank Global M ar kets Resea rch
13 OfOptimal Maturity of Issuance
14 Definition of the problem
Overview - Across a range o f 15 econom ic an d cre dit scenar ios, we pro jec t f undi ng need s over th e next 10 years - Our goal is to find the optimal average maturity of debt issuance given different risk scenarios over the next 3 years Setup of problem:
- Decision variable: % gross issuance of 2009-2011 to be issued in 3-months and 10-years - Objective: Minimize the total cost of debt service from 2010-2020 (try to consider a confidence crisis on sovereign credit by 2020) - Constraints: -Maintain enough net issuance in bills and 10-years to meet investor needs -Additional Consideration -Keep yields within a range to achieve monetary policy goals
15 Overview of the model
Contingent Real Growth Inflation Liabilities
Annual Issuance Credit Spreads Shape of Yield Duration Suppl y Maturity of (Deficit) Curve Issuance
Cost of Debt
16 Macro and credit scenarios
The model considers 15 scenarios: – 5 mmacroacro scescenarios:narios: cocombinationsmbinations ooff ggrowthrowth aandnd inflinflationation – 3 credit scenarios: optimistic, base case and disaster
Four focus scenarios
Credit Losses Real Fannie / Extraordinary Scenario Description Inflation Growth Freddie FDIC Assistance Total 1 Base Case 2% 2% $300 $200 $75 $575 2 Low Growth, low inflation (Japan) 0% 0% $300 $200 $75 $575 3 Moderate growth, high inflation 2% 5% $300 $200 $75 $575 4 High credit loss 2% 2% $600 $600 $200 $1,400
17 Yield curve dynamics
♦The 10-year rate is the sum of: - Real growth rate -Inflation -Credit spread: based on amount of credit losses -Inflation risk premium: 50 bps + 20% of current inflation -An adjustment for duration supply: assume $1trn in net issuance leads to 1% increase in yields. * ♦The 3-month point is largely determined by the Fed: - Taylor rule: d(3-month Yield) = 1.5 * d(Inflation) + 0.5 * d(Real Growth) - The 3-month credit spread is smaller than the 10-year spread and varies by credit scenario - The impact of duration supply is small: $1trn in net issuance increases yields by 7 bps
Rates in 2020 across focus scenarios
Impact of CCedtredit Inflatio n SiScenario GthGrowth IfltiInflation Durn 10-yr Yield 3m YildYield Debt / GDP Spread Risk Prem Supply Base 2.0% 2.0% 0.25% 0.9% 2.3% 7.5% 2.9% 123% Japan 0.0% 0.0% 0.25% 0.5% 2.1% 2.8% 0.0% 149% High Inflation 20%2.0% 50%5.0% 0. 25% 15%1.5% 29%2.9% 11. 7% 74%7.4% 117% High Credit 2.0% 2.0% 1.75% 0.9% 2.9% 9.6% 4.3% 140%
* A recent study by JP Morgan concluded that net issuance of 10yrs in the amount of 1% of GDP causes yield to rise by 30bps. This would imply that yields would rise by 2% given $1 trn in issuance. We found this lead to yield curves that were implausibly steep b y 2020 so we h al ved th e eff ect . W e d o f eel th at th e eff ect we used i n our mod el i s on th e conservati ve sid e.
18 Budget outlook across scenarios
Federal budget in focus scenarios
2011 Yield Curve 2020 Yield Curve
% Bill in Avg Deficit / Debt Service Gross MtMaturity it of Avg MMtitaturity GDP De bt / GDP / GDP in Scenario Supply Issuance of Debt 2011 3m 10y 3m 10y (2015-2020) in 2020 2020 Base 56% 55 74 2.2% 5.8% 2.9% 7.5% 9% 123% 7% Japan 81% 26 51 0.2% 2.8% 0.0% 2.8% 7% 149% 3% High Inflation 3% 116 96 4.4% 7.8% 7.4% 11.7% 11% 117% 9% High Credit 42% 70 83 2.6% 7.0% 4.3% 9.6% 9% 140% 9%
19 Optimization across scenarios
♦In the low growth / low inflation scenario, we want to keep issuance as short as possible ♦In the high inflation scenario, we should issue long now to lock in low rates
Average Debt Service / GDP: 2015-2020
10.00%
9.00% 116 (96) 8.00% 7.00%
6.00% 70(83) 5.00% 55 (74) 4.00% 3.00% 2.00% 26 (51) 12 18 24 30 36 42 48 54 60 66 72 78 84 90 96 102 108 Maturity of Debt Issuance
Base Case Japan High Inflation High Credit Loss
Line shows optimal maturity of issuance to minimize total debt service cost for 2009-2020 Number in parentheses is average maturity of total debt at the end of 2011
20 Optimal issuance across macro and credit scenarios
Current macro environment Recent Issuance Yield Curve Real % of Deficit / Debt / Debt Service IfltiInflation MtMatur ity 3m 10y Growth Bills GDP GDP / GDP -1% 1% 70% 26 0.08% 3.59% 14% 50% 1.3%
Optimal issuance for a given macro environment
Base Case Tax Rate 30% Higher Taxes Optimal Issuance Yield Curve in 2020 Debt Optimal Issuance Yield Curve in 2020 Debt Deficit / Debt / Deficit / Debt / % Bills in Service / % Bills in Service / Real Debt GDP GDP in Debt GDP GDP in Inflation Gross 3m 10y GDP in Gross 3m 10y GDP in Growth Maturity (2015-20) 2020 Maturity (2015-20) 2020 Supply 2020 Supply 2020 0% 0% 80.6% 26 0.2% 2.8% 7.4% 149% 3.5% 83.6% 22 0.2% 2.7% 4.9% 112% 2.5% 2% 2% 55.6% 55 2.2% 5.8% 8.9% 123% 6.6% 60.4% 49 2.2% 5.7% 5.5% 87% 4.6% 2% 5% 3.4% 116 4.4% 7.8% 11.1% 117% 9.3% 10.5% 108 4.4% 7.8% 7.4% 81% 6.1% 4% 0% 62.7% 47 1.2% 5.5% 7.0% 107% 5.4% 66.9% 42 1.2% 5.3% 2.8% 71% 3.6% 4% 5% 0.0% 120 4.9% 8.8% 10.6% 96% 8.8% 0.0% 120 4.9% 8.8% 5.4% 60% 5.4% Oppgtimal issuance for a given macro/credit environment
Base Case Tax Rate 30% Higher Taxes Optimal Issuance Yield Curve in 2020 Debt Optimal Issuance Yield Curve in 2020 Debt Deficit / Debt / Deficit / Debt / % Bills in Service / % Bills in Debt Service / Real Credit Debt GDP GDP in GDP GDP in Inflation Gross 3m 10y GDP in Gross Maturity 3m 10y GDP in Growth Losses (bn) Maturity (2015-20) 2020 (2015-20) 2020 Supply 2020 Supply (mos) 2020 0% 0% $6 82.7% 23 0.1% 2.5% 7.4% 142% 2.9% 85.7% 20 0.1% 2.4% 4.8% 105% 2.1% 0% 0% $575 80.6% 26 0.2% 2.8% 7.4% 149% 3.5% 83.6% 22 0.2% 2.7% 4.9% 112% 2.5% 0% 0% $1,400 73.1% 34 0.6% 4.0% 7.9% 168% 5.9% 76.3% 31 0.6% 3.9% 5.6% 128% 4.3% 2% 5% $6 6.5% 112 4.4% 7.5% 11.1% 111% 8.6% 13.2% 105 4.4% 7.5% 7.2% 75% 5.5% 2% 5% $575 3.4% 116 4.4% 7.8% 11.1% 117% 9.3% 10.5% 108 4.4% 7.8% 7.4% 81% 6.1% 2% 5% $1,400 0.0% 120 4.8% 8.8% 11.7% 132% 12.0% 0.0% 120 4.8% 8.8% 8.2% 93% 8.1%
21 Impact of duration supply
♦ Our choice of maturity is highly dependent on the impact of duration supply on yields ♦All else eqqgggp,pyual if issuing more long debt has a larger impact on rates, the optimal maturity will be shorter
Average Debt Service Across all Scenarios / GDP: 2015-2020
9.00% 8.50% 8.00% 7.50% 56 months 7.00% 6.50% 6.00% 5.50% 79 months 5.00% 12 18 24 30 36 42 48 54 60 66 72 78 84 90 96 102 108 Maturity of Debt Issuance
$1 trn in issuance -> 1% in yield $1 trn in issuance -> 2% in yield
22 Implications of monetary policy constraints for debt issuance
♦ The lowest-cost issuance strategy may lead to yields that conflict with monetary policy goals ♦ If we restrict ourselves to strategies that limit near-term bond yields, the maturity of issuance will be shorter
Issuance strategies across targeted yields
Average MMiaturity Maximum Allowed 10- of Issuance 2009- Debt Service / GDP Year Yield 2011 Debt Maturity 2011 2015-2020 * None 79 87 5.7% 55%5.5% 74 84 57%5.7% 5.0% 56 75 5.8% 4.5% 41 65 5.9% 4.0% 28 53 6.2% 3.5% 16 41 6.7% 3.0% 15 39 6.8%
* Maximum across all scenarios ** Average across scenarios
23 The choice of maturity matters, but without budgetary restraint the cost of debt could spiral
♦ In a high credit loss, high inflation scenario issuing long-dated debt from 2009-2011 can reduce debt service cost in 2020 by 13% of government revenues ♦ But even with the optimal maturity debt service costs will be unbearable ♦The dashed lines assume spending is cut by 30% by 2012
Debt Service as % of Federal Revenues: High Inflation, High Credit Scenario
90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
Maturity of debt issued 2009-2011: 25 Months 54 Months 120 Months
24 Recap
Four Conclusions: 1. Inflation, higher interest rate and roll over risk should be the primary concerns in Treasury’s debt management strategies. 2. In most scenarios, it is prudent to lengthen maturities significantly from current average maturity of 50 months. Our base case is to extend to 74 months, stretch case to extend to 96 months. 3. The objective of lowest borrowing cost could lead to higher yields that conflict with monetary policy objective. 4. Clever debt management strategy could potentially reduce debt service cost meaningfully, but still can’t completely substitute for prudent fiscal policy.
25 Future Research
♦ We did not fully consider entitlement and state and local government as potential contingent liabilities . Hence risk to the model is to the upside . ♦ We can enhance the model on duration supply going forward. Current literature focused on historical regression. Possible new variables to consider: oil, dollar debasement, change of foreign demand , and US saving rate . ♦ We can attempt to model the rollover risk in a different context. We can tie the front end credit spread to the amount of short term debt maturing within a certain time frame.
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