The Fed giveth and the Treasury taketh away.
Last September, the Federal Reserve began implementing a program to sell $400 billion of its holdings of Treasury securities of 3-years duration and shorter and use the proceeds to invest in 6- to 30-year securities instead. This June the Fed announced that it would do the same with an additional $267 billion in securities. Some analysts expect the Fed to announce additional related measures after the next FOMC meeting.
The theory behind such measures is discussed in this statement from the Federal Reserve:
By reducing the supply of longer-term Treasury securities in the market, this action should put downward pressure on longer-term interest rates, including rates on financial assets that investors consider to be close substitutes for longer-term Treasury securities. The reduction in longer-term interest rates, in turn, will contribute to a broad easing in financial market conditions that will provide additional support for the economic recovery.
One could thus view the Maturity Extension Program as a deliberate effort by the Fed to undo the consequences of previous Treasury decisions for the composition of debt held by the public. A number of academic studies have looked at whether changes in the maturity composition of publicly held Treasury debt really do affect bond yields. Gagnon, et. al. (2010), Greenwood and Vayanos (2010), Swanson (2011), and
Hamilton and Wu (2012) all found that historical changes in the maturity composition are correlated with small changes in long-term yields. Studies of the particular effects of the Fed’s recent operations include D’Amico and King (2010), Hancock and Passmore (2011), Krishnamurthy and Vissing-Jorgensen (2011) and Wright (2011), all of whom found effects consistent with the theory.
I was interested to learn this week that the U.S. Treasury in turn may be deliberately trying to undo the consequences of the Fed’s Maturity Extension Program. David Beckworth calls attention to the Office of Debt Management Fiscal Year 2012 Q3 report. In trying to understand some of these charts, I was led to the minutes of the latest meeting of the Treasury Borrowing Advisory Committee, where I was surprised to read this:
The presenting member noted that the original MEP lowered Treasury’s borrowing capacity through 2016 by $400 billion and that the extension of MEP lowered it by an additional $267 billion.
I would love to find more explanation of what this statement means (and welcome instruction from any readers knowledgeable of the institutional details). Here is my best effort at understanding it. Suppose that the Treasury owes $400 B in 10-year debt which has been issued evenly over the last 10 years. Then each year it will need to auction $40 billion in new 10-year securities. Alternatively, if the Treasury owes $400 B in 1-year debt, each year it will have to auction $400 B in new 1-year securities. So its funding needs in terms of cash flow operations are bigger if the maturity structure of its outstanding debt is shorter.
But the puzzling thing about this statement to me is that, regardless of whether the public or the Fed owns those $400 B in 1-year securities, the Treasury is still going to have to auction $400 B each year to the public, because the Fed is required to buy Treasury securities on the open market rather than from the Treasury itself. So, prior to the Fed’s MEP, the Treasury had to auction $400 B in new bills each year (which the Fed subsequently bought), and after the Fed’s MEP, the Treasury still has to auction $400 B in new bills each year (which now must remain in the hands of the public).
The statement from the TBAC minutes suggests to me that in practice, these two outcomes are viewed as very different by the Treasury. In the first case, $400 B is auctioned to the “public”, but the dealers bidding on the securities know that the Fed is shortly going to take them off their hands, and this determines their willingness to bid. But in the second case, the demand from the “public” may not be there if the Fed is no longer buying up these T-bills.
OK, but that’s how these operations are supposed to work: force the public to hold a higher portion of bills and lower portion of bonds in hopes of twisting the yield differential. But the TBAC minutes continue:
Next, the presenting member reviewed various scenarios by which Treasury could finance this [MEP-induced] gap, including financing with bills, coupon securities or floating rate notes. According to the presenter, depending on how Treasury finances the effect of MEP, the average maturity at the end of FY2016 could range from 67.5 month to 70.2 months.
Committee members then debated the best way to fund the short-term effect of MEP. Some members noted that increasing coupon issuance to fund the MEP shortfall would be consistent with the Committee’s long standing recommendation to extend the weighted average maturity.
Beckworth was interested in this picture from the Office of Debt Management 2012 Q3 report. As described in the report, this is simply a projection of what the current Treasury issuance percentages (which include significantly more long-term securities and less short-term securities than normal) would imply if continued into the future.
The TBAC minutes provide this added information:
[Office of Debt Management Director Colin] Kim reviewed several debt metrics. As of June 30, 2012, the average maturity of the portfolio was approximately 64.2 months. In the chart presentation showing the projections for Treasury’s weighted average maturity, Kim adjusted future note and bond issuance on a pro-rata basis to match projected financing needs. The simulation showed that the average maturity continues to extend well above the 3 decade average of 58.1 months. By 2016 it could reach the upper end of the historical range.
He emphasized that the average maturity projections and the associated underlying assumptions for future issuance were hypothetical and not meant to convey future debt management policy or an average maturity target. He also reiterated that Treasury will remain flexible in the conduct of debt management policy.
The report also provides this summary of the composition of outstanding Treasury debt and what current procedures would imply for the future composition.
All of which leads me to conclude that, if new policy initiatives are announced at the next FOMC meeting, they will not take the form of more twisting and maturity extension, but instead would consist of large outright purchases.