This Is No Way to Fund the Deficit
It is usually several months later in the year that I begin my annual lament over the state of the U.S. federal budget. Not so much the deficit -- which is too high, but manageable -- but rather the foolhardy method we have for funding it. (See recent discussions here, here, and here).
I am not going to spend too much time on the issue of a long bond, other than to reiterate this simple formulation: Demand for Treasuries + ultralow rates + big, persistent U.S. funding needs = need for a long bond, preferably one that matures in as much as 50 years. However, there is an enormous difference between the abstract debate over how big our deficit is or should be and the more pragmatic discussion of how best to fund it.
The latter is our subject matter for today. Despite near-record low interest rates -- the 10-year Treasury bond yields less than 1.9 percent -- we finance our deficits with lots of short-term debt, rolling it over constantly. There are any number of problems with this approach: Funding could be subject to disruptions if we have another financial crisis; the administrative costs are more expensive than they need be; and it misses the opportunity to match duration of long-term, persistent obligations with long-term, stable funding.
But rather than taking a sensible approach to deficit funding, it seems like we're going in the opposite direction based on the latest statement from the Treasury Department:
In November 2015, Treasury reiterated intentions to increase Treasury bill issuance . . . Treasury is announcing reductions of $1 billion to each of the next 5-year, 7-year, 10-year, and 30-year nominal coupon offering sizes, for both new issues and reopenings. In aggregate, relative to what would have been issued under the previous schedule, nominal coupon issuance will be reduced by $12 billion over the upcoming quarter. These adjustments will begin with the 10- and 30-year nominal note and bond auctions being announced today. . . Treasury is also announcing downward adjustments to the offering sizes for all TIPS tenors over the next quarter. Specifically, Treasury is announcing reductions of $2 billion to each of the next 5-year, 10-year, and 30-year TIPS offering sizes . . . TIPS issuance will be reduced by $6 billion over the upcoming quarter. (Emphasis added.)
Just a reminder that Treasury bills are obligations that mature in one year or less. So how to read the statement above: More short-term debt, $18 billion less in long-term bonds.
If that sounds a bit familiar, it's because it is a variation on what the Federal Reserve did with Operation Twist, one of the tools it tried in its program of quantitative easing. In Operation Twist, the Fed sold short-term government bonds and bought longer-dated Treasuries. Here, Treasury is issuing more shorter debt and doing the closest thing to buying long-dated debt by issuing less of it. Hence, as an issuer, its total duration balance is being “twisted” away from the longer term.
The net result of this is to drive long-term rates, QE style, even lower. Some have even wondered if the goal is a short squeeze on Treasury bond bears, who have been betting on higher rates.
All of this takes place within the context, as we have previously discussed, of a worldwide shortage of high-quality debt:
On the supply side, we are not seeing the usual pattern that follows U.S. recessions. Typically during an economic slowdown there is a surge of stimulus spending, financed by issuing debt. We saw that in 1990-91 and 2001. The pattern was broken this go around. The Great Recession was especially hard on regional economies, forcing state and local governments to absorb enormous spending cuts and reduce their headcounts. Congressional incompetence and intransigence thwarted much of the usual post-recession federal spending and debt issuance.
The Fed ended QE in 2014 and began raising rates at the end of last year, and had signaled additional increases may come this year. The Treasury Department now muddies the waters with this new program, despite the obvious mismatch in obligations and funding vehicles.
I don't want to make too much of this, especially when you consider the scale of this move against the backdrop of the $13 trillion in federal debt. But it makes me wonder if anyone in the government has a firm grip on the tiller of funding management.
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