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Last updated: January 31, 2014 1:43 pm
This week the US government delivered two pieces of noteworthy news. One caused a splash: on Wednesday the Federal Reserve announced another $10bn cut in its monthly bond purchases, the second time it has tapered. Cue Twitter alerts and headlines.
But the real drama came a few hours earlier, when Uncle Sam successfully sold $15bn of two-year floating-rate notes to investors in the first innovation in federal debt for 16 years. The sale of these bonds that reset according to market rates – thus avoiding any losses if rates rise – attracted a startling $85bn of orders; not that you would have noticed from following the media, whether social or mainstream.
On one level this disparity is no surprise. Government bond auctions tend to be technical affairs. The Fed’s taper, by contrast, is replete with drama for global investors, particularly since it could trigger more volatility for emerging markets.
But investors and taxpayers would be foolish to ignore the “floaters”. What they show is the degree to which Treasury officials are hunting for ways to ensure the US can keep selling its debt to global investors when interest rates rise. And the outcome of those discreet experiments could prove critical to whether that much-debated taper will play out smoothly – or not.
The issue at stake partly revolves around the manner in which the Treasury sells government debt. In the past this was done in a straightforward way: bonds carried fixed interest rates, and most of these were either short-term bills or 10-year ones. Until recently US officials saw little reason to change this approach as demand was sky high.
But now a business-as-usual course is starting to look dangerously complacent. Never mind the fact that the US debt pile has doubled to $17tn in the past decade; and ignore recent fiscal fights and the threat of a new debt-ceiling showdown. The other challenge haunting the Treasury is the maturity profile of the debt.
In the past three decades this maturity has averaged 58 months, meaning it must be renewed almost every five years. During the financial crisis it declined to four years – half the average maturity of most European countries. That produced one oft-ignored benefit: because the Fed has kept rates ultra-low, total interest costs have not risen as fast as total debt. Just like a homeowner on a floating mortgage, low rates have meant low monthly interest payments for the Treasury. Indeed, interest payments now represent 6 per cent of federal outlays; two decades ago it was 15 per cent.
But this benefit comes with a sting that mortgage borrowers know well: if rates increase, interest payments could balloon. And if investors panic about inflation, higher rates or fiscal sustainability, that squeeze could be more intense.
The good news is that the Treasury is aware of this danger, and trying to prepare. In recent months it has had success in raising the average maturity profile by selling more long-term bonds. This stands at 66.7 months, and officials say that by 2020 it could reach 80.
Treasury officials are also trying to help the market absorb future rate rises by offering a more flexible range of instruments. This week’s experiment with floaters is one move. However, the Treasury is also selling inflation-protected bonds and officials are getting more proactive about asking large investors – including Asian buyers – what moves will keep them purchasing Treasuries. “They really want [customer] feedback,” says the head of one large Asian sovereign wealth fund. In the last Treasury Borrowing Advisory Committee meeting, banks and investors decided to start working with Treasury officials on “a framework for thinking about an optimal debt issuance strategy” for the first time.
But while these moves are smart, the $17tn question remains: will this be enough? This week’s convergence of events gives some reason for cheer: by any standards, the sale of those floaters was a storming success in terms of raising money cheaply. But as the Fed keeps winding down quantitative easing, the challenge around debt issuance will become more intense, along with the need for flexible innovation. Or to put it another way, what the Treasury’s debt team desperately needs – just like the Fed – are the skills and tools to find a smooth glide path. And that is never easy; least of all when Congress keeps delivering new jolts.
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