Black ink in the federal budget is good news for almost everyone except Wall Street. The government's new surpluses are a pain in the neck for the financial institutions that have come to depend on the deep pool of Treasury securities that were issued by the government to cover chronic deficits. Pension funds use long-term Treasury bonds to cover payouts to future retirees. The Federal Reserve controls the money supply by temporarily buying Treasuries from banks or letting its purchases from them expire, as needed. Hedge funds and other traders finance their speculation through the huge Treasury repo market.
Without Treasuries, each of these enormous markets must be rebuilt from the ground up. In the meantime, everything from the mechanics of monetary policy to corporate borrowing is up in the air. No wonder an executive at one big New York bank, who asked not to be identified, said, "Ultimately, the capital markets and the U.S. government will regret this move toward elimination of the debt."
HEALTHY CHANGE. But even as they gripe, players in the capital markets are learning to adjust to a world in which Treasuries lose their role as the benchmark for the entire credit market, from mortgage securities to junk bonds. Slowly, they're gravitating toward new securities that can play the roles Treasuries have played.
The change should be healthy in the long run. It will free the financial markets from overdependence on Treasuries, which have become erratic and unreliable. With less reliance on Treasuries, "I believe we will see a much more stable environment for trading and hedging," Stan Jonas, a managing director at FIMAT Futures USA Inc., a futures trading firm, said at a recent symposium put on by the Federal Reserve Bank of New York.
Why? Because Treasuries no longer do what a benchmark should do. Bond market pros have long quoted the yields of other debt securities in terms of their relationship to Treasuries of the same maturity. For instance, a certain corporate bond might be priced at issue to yield two percentage points above the 10-year Treasury note. The logic for pricing off Treasuries was that since they were free of default risk, they were a stable anchor for value.
These days, though, pricing bonds by reference to Treasuries has become like comparing your height to that of a kid on a pogo stick. The difference in yield between Treasuries and other securities is anything but stable. With the supply outlook uncertain as budget deficits dwindle, Treasury prices have become increasingly volatile. This year they have risen sharply, driving yields lower. The yield gap between 10-year Treasuries and 10-year BBB+ corporate bonds has widened from 1.26% to 1.74%--a huge change in a business where every basis point, or hundredth of a percentage point, counts.
The shift away from Treasuries isn't easy for finance types who have been drilled on their centrality since business school. "What you're doing is slashing the value of every MBA that's been granted in the last 20 years," says Louis B. Crandall, chief economist at Wrightson Associates, a New York bond research firm.
Still, change is coming. Federal Reserve Chairman Alan Greenspan has taken to citing the yield on BBB+ corporate bonds as a marker of interest rates instead of Treasuries. And bond market players are looking at non-Treasury interest-rate indicators to decide what bonds should be worth. One new benchmark is the corporate debentures of Fannie Mae and Freddie Mac, the huge government-sponsored mortgage finance companies. The Chicago Board of Trade and Chicago Mercantile Exchange recently began trading futures and options on Fannie Mae and Freddie Mac debentures.
SWAPPING BENCHMARKS. Skeptics argue that Fannie Mae and Freddie Mac shouldn't serve as interest-rate benchmarks because their debt isn't government-guaranteed, as Treasuries are. But that misconstrues the role of a benchmark. To be useful as a measuring rod, a benchmark should have a stable relationship with other debt. Fannie Maes and Freddie Macs are starting to fulfill that role. The risk is that their emergence as benchmarks could overstimulate the demand for them--and increase the pressure on the government to bail them out if they get in trouble.
There's another benchmark that's even better than Fannie Maes and Freddie Macs, which still aren't widely traded enough for the biggest players. It's the so-called swap rate, which has been the benchmark in Europe for years, and is catching on in the U.S. The swap rate is based on LIBOR, the London Interbank Offered Rate, which is the rate that banks with top credit ratings charge each other for short-term dollar loans. In a typical swap, one party pays the LIBOR rate, which fluctuates daily. The counterparty pays a rate that will be fixed for the term of the swap agreement, which could be anywhere from a week to 30 years. That fixed rate is based on the parties' expectations for long-term interest rates. The swaps market isn't affected by ups and downs in supply, as the Treasury market is. Recently Ford Motor, General Motors, and Wells Fargo have used the swap rate as a benchmark for debt issues.
Of course, Treasuries aren't just a measuring stick. They're also the ultimate store of value because they're virtually free of default risk. In that role, they're hard to replace. Still, the market is groping toward substitutes. For instance, the Federal Reserve has always relied on Treasuries to conduct monetary policy. But last year, as a Y2K precaution, it said it would accept other securities such as certain state, local, and foreign-government debt as collateral from banks that needed to raise money quickly to meet depositors' demands. That liberalization has been extended to next January and is likely to be made permanent.
Investors who once insisted on U.S. Treasuries are recognizing that they can get much more attractive yields elsewhere for only slightly more risk. Pension funds are stepping up purchases of mortgage securities and highly rated corporate bonds. Foreign investors are branching out, too. As recently as 1996, nearly all of foreigners' long-term portfolio investment flows went into Treasuries. Last year, though, as overall inflows increased, the money going into Treasuries dropped to nearly zero (chart). To capitalize on the trend, Fannie Mae and Freddie Mac are actively marketing their debt abroad.
RISK-AVERSE. To be sure, there will always be investors who want only Treasuries. The Bank of Japan, for instance, is unlikely to develop a taste for junk bonds. But the continued need for some Treasuries isn't a problem because they will never go away entirely. The Congressional Budget Office is projecting that by 2010 there will still be nearly $1 trillion in Treasury bonds outstanding, even if the government surplus is large enough to buy them all back. That's because risk-averse investors are likely to bid up the remaining Treasuries so high that it would be a waste of taxpayers' money to retire them.
Another reason there will still be Treasury bonds--aside from the possibility of fresh red ink in the budget--is that Treasury may start to issue bonds on behalf of other agencies that currently raise their own money at higher costs. Recently, for instance, the Government National Mortgage Assn. asked Treasury for $60 billion to retire some relatively high-yielding debt. The danger is that Congress will start using Treasury's borrowing power for less creditworthy endeavors.
Federal surpluses are throwing the credit markets into a tizzy. But markets are adjusting. They always do.