As the rest of Washington fixated on tax reform and a new Federal Reserve chair last week, the Treasury Department unveiled a borrowing strategy lacking fanfare but having potentially big implications for the bond market and the U.S. economy.
In a step that could limit upward pressure on long-term interest rates from bigger budget deficits and a reduced Fed balance sheet, the Treasury will break from a policy in place since 2009 and stop attempting to lengthen the maturity of the government’s debt.
“The Treasury is trying to avoid making the mistake of throwing out long-maturity debt where there isn’t sufficient demand, which could really steepen the yield curve,” said Gene Tannuzzo, a money manager at Columbia Threadneedle Investments, which oversees $484 billion. It “seems to be making an effort to avoid a yield shock.”
That’s important for the health of the economy. Yields on longer-term Treasury debt serve as benchmarks for everyone from home buyers to corporate treasurers. A “steepening is where we could get into problems with the housing market,” Tannuzzo said.
It’s probably also welcome at the Fed, which has begun to slowly reduce its balance sheet by not rolling over some of the maturing Treasury and mortgage-backed securities in its portfolio. Fed policy makers have gone out of their way to make the unwind as painless as possible for the bond market—and the Treasury’s new approach will help in that regard.
The shift comes as a surprise. It wasn’t that long ago that Treasury Secretary Steven Mnuchin was talking about issuing an ultra-long bond with a maturity of more than 30 years. While Mnuchin signaled he was backing away from that idea in a Bloomberg interview late last month, Treasury officials went further in the department’s quarterly refunding announcement last week.
“We’re looking at kind of a stabilization from here” in the weighted average maturity (WAM) of Treasury debt, acting Assistant Secretary for Financial Markets Monique Rollins said at a press briefing in Washington on Nov. 1.
The average maturity of the $14 trillion-plus in marketable Treasury debt outstanding was at a near multidecade high of more than 70 months on Sept. 30. That’s up from 49 months in December 2008 and is above the 60-month historical average dating back to 1980. But it’s still about a year less than the average of the Group of Seven industrial nations, according to data compiled by the International Monetary Fund.
The Treasury maintained its longer-term debt sales at $62 billion this quarter for the seventh straight time, opting to meet any increased financing needs from run-offs by the Fed through the sale of bills. The yield curve flattened in response as the attraction of holding longer-term Treasuries grew.
The department’s decision means that “at least initially, the Treasury is completely offsetting the impact of the Fed unwind” on long-term interest rates, said Seth Carpenter, chief U.S. economist at UBS Securities and a former Fed and Treasury official.
The central bank began reducing its holdings of Treasury and mortgage-backed securities in October, initially limiting the monthly draw-down to $6 billion of the former and $4 billion of the latter. The caps will be gradually increased to an eventual $30 billion for Treasuries and $20 billion for housing debt.
The alteration in the Treasury’s approach doesn’t mean the bond market will be spared from having to digest extra supply as the Fed unwind continues and budget deficits increase on the back of potential tax cuts. Indeed, Treasury officials last week flagged the likelihood of stepped-up sales in future refundings. The department will “look at raising auction sizes,” Rollins said.
What it does mean though is that Treasury won’t be actively adding to the pressure on the long end.
“The risk of disproportionate increases in long-end borrowing has 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 the financial crisis. Faced with $1 trillion plus budget deficits at a time when rates were also near record lows, the Treasury ramped up auctions of longer-dated securities with an aim to also lock in low funding costs for years to come.
That led to criticism—most prominently by former Treasury Secretary Lawrence Summers—that the department was working at cross-purposes with the Fed, which at that time was aggressively trying to bring down long-term interest rates by buying bonds through its quantitative easing programs.
In announcing the change in its borrowing strategy, Treasury officials also appeared to de-emphasize the concept of weighted average maturity as a lodestone for debt policy, making clear that the focus instead was on getting the best deal for the taxpayer in the long run.
Carpenter, who oversaw debt sales when he was at Treasury from 2014 to 2016, called the change a “good thing.”
“Interest expense is a huge share of the deficit,” he said. “The Treasury’s recent statement shows their objective to fund the government at the lowest cost over time.”