As the rest of Washington fixated on tax reform and a newFederal Reserve chair last week, the Treasury Department unveiled aborrowing strategy lacking fanfare but having potentially bigimplications for the bond market and the U.S. economy.

In a step that could limit upward pressure on long-term interestrates from bigger budget deficits and a reduced Fed balance sheet,the Treasury will break from a policy in place since 2009 and stopattempting to lengthen the maturity of the government's debt.

“The Treasury is trying to avoid making the mistake of throwingout long-maturity debt where there isn't sufficient demand, whichcould really steepen the yield curve,” said Gene Tannuzzo, a moneymanager at Columbia Threadneedle Investments, which oversees $484billion. It “seems to be making an effort to avoid a yieldshock.”

That's important for the health of the economy. Yields onlonger-term Treasury debt serve as benchmarks for everyone fromhome buyers to corporate treasurers. A “steepening is where wecould get into problems with the housing market,” Tannuzzosaid.

It's probably also welcome at the Fed, which has begun to slowlyreduce its balance sheet by not rolling over some of the maturingTreasury and mortgage-backed securities in its portfolio. Fedpolicy makers have gone out of their way to make the unwind aspainless as possible for the bond market—and the Treasury's newapproach will help in that regard.

The shift comes as a surprise. It wasn't that long ago thatTreasury Secretary Steven Mnuchin was talking about issuing anultra-long bond with a maturity of more than 30 years. WhileMnuchin signaled he was backing away from that idea in a Bloomberginterview late last month, Treasury officials went further in thedepartment's quarterly refunding announcement last week.

“We're looking at kind of a stabilization from here” in theweighted average maturity (WAM) of Treasury debt, acting AssistantSecretary for Financial Markets Monique Rollins said at a pressbriefing in Washington on Nov. 1.

Rising Maturities

The average maturity of the $14 trillion-plus in marketableTreasury debt outstanding was at a near multidecade high of morethan 70 months on Sept. 30. That's up from 49 months in December2008 and is above the 60-month historical average dating back to1980. But it's still about a year less than the average of theGroup of Seven industrial nations, according to data compiled bythe International Monetary Fund.

The Treasury maintained its longer-term debt sales at $62billion this quarter for the seventh straight time, opting to meetany increased financing needs from run-offs by the Fed through thesale of bills. The yield curve flattened in response as theattraction of holding longer-term Treasuries grew.

The department's decision means that “at least initially, theTreasury is completely offsetting the impact of the Fed unwind” onlong-term interest rates, said Seth Carpenter, chief U.S. economistat UBS Securities and a former Fed and Treasury official.

The central bank began reducing its holdings of Treasury andmortgage-backed securities in October, initially limiting themonthly draw-down to $6 billion of the former and $4 billion of thelatter. The caps will be gradually increased to an eventual $30billion for Treasuries and $20 billion for housing debt.

The alteration in the Treasury's approach doesn't mean the bondmarket will be spared from having to digest extra supply as the Fedunwind continues and budget deficits increase on the back ofpotential tax cuts. Indeed, Treasury officials last week flaggedthe likelihood of stepped-up sales in future refundings. Thedepartment will “look at raising auction sizes,” Rollins said.

What it does mean though is that Treasury won't be activelyadding to the pressure on the long end.

“The risk of disproportionate increases in long-end borrowinghas faded,” is how Lou Crandall, chief economist at Wrightson ICAP,put it in a Nov. 6 note to clients.

That's in contrast to the situation that prevailed after thefinancial crisis. Faced with $1 trillion plus budget deficits at atime when rates were also near record lows, the Treasury ramped upauctions of longer-dated securities with an aim to also lock in lowfunding costs for years to come.

That led to criticism—most prominently by former TreasurySecretary Lawrence Summers—that the department was working atcross-purposes with the Fed, which at that time was aggressivelytrying to bring down long-term interest rates by buying bondsthrough its quantitative easing programs.

In announcing the change in its borrowing strategy, Treasuryofficials also appeared to de-emphasize the concept of weightedaverage maturity as a lodestone for debt policy, making clear thatthe focus instead was on getting the best deal for the taxpayer inthe long run.

Carpenter, who oversaw debt sales when he was at Treasury from2014 to 2016, called the change a “good thing.”

“Interest expense is a huge share of the deficit,” he said. “TheTreasury's recent statement shows their objective to fund thegovernment at the lowest cost over time.”

From: Bloomberg News

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