Bob Rubin's Bond Bind

The cash-rich Treasury needs to issue less debt--but that could hurt liquidity

It's a Treasury Secretary's dream. The economy is unbelievably robust, with low inflation, surging productivity, and healthy surpluses. The federal government is flush with cash. Indeed, the current schedule of debt auctions will raise far more money than the federal government needs.

You'd think, then, that Robert E. Rubin would be in heaven. But you'd be wrong. In fact, Rubin knows he has to stop the flood of cash. As cash has been piling up, the government has had to sharply cut back issuing bonds. That "makes for a less efficient capital market," says Kevin M. Flanagan, money-market economist at Morgan Stanley Dean Witter. Fewer bonds sloshing around the marketplace, further, makes it more difficult for traders to determine a bond's true market value. In addition, bond prices are likely to be more volatile if they are harder to obtain, Flanagan says.

CREDIBILITY CRUNCH? Rubin's dilemma is vexing. He must be careful not to do anything too abrupt and risk damaging what many economists consider the most liquid market in the world. If Rubin reduces the supply of Treasury securities, that could damage the credibility of Treasurys as risk-free instruments and globally recognized benchmarks. On the other hand, if he doesn't pare back the lineup of debt auctions, he'll have too much cash on his hands. "If budget surpluses prove durable, it pushes the Treasury into a position where they have to shrink the volume of debt sales," says Goldman, Sachs & Co. senior money-market economist John M. Youngdahl. "The Treasury is boxed in."

Just last May, Treasury thought it had the problem licked. He discontinued new issues of three-year notes and reduced the frequency of five-year note sales. That pushed Treasury's total debt issuance in 1998 to a six-year low of $1.97 trillion (table), down 9.2% from 1997's $2.17 trillion, according to the Bond Market Assn. But Treasury again had to cut back in February when it announced reduced sales of 5- and 10-year notes.

Such cutbacks, while significant, still haven't done the trick. Treasury's borrowing needs are far less than it envisioned just two months ago. In February, Treasury held three auctions to raise $8 billion and roll over $27 billion worth of notes. For the year, the average auction size is expected to be $13.6 billion. But even at Treasury's scaled-back rate, it will raise some $45 billion more than is needed for fiscal 2000, which begins in October, says Goldman's Youngdahl. Future auctions either must shrink in dollar volume, or Treasury must hold fewer auctions at a time when the surplus is expected to hit a heady $80 billion. The result: Rubin & Co. are going to have to restructure the way the $300 billion-a-day government bond market works.

Some economists expect Rubin to resolve his dilemma by the time of Treasury's next quarterly funding announcement in early May. Wall Street experts say Treasury is focusing on several options. The government could continue to reduce the number of times it issues debt by cutting back on two-year notes that are now sold once a month. Treasury also could sell 30-year bonds less frequently than the current three times a year. Both options, which would be relatively painless for bond dealers to adjust to, are under active consideration--but that still might not be enough.

POLITICAL ROADBLOCK. One option gaining support calls for Treasury to buy back outstanding debt from investors and get rid of bonds that it sold in years past when interest rates were higher. Such debt retirement could save taxpayers a lot of money in the long run--though not initially. The reason: Current accounting rules require the entire repurchase cost to show up as a budget expense that year. And with existing bondholders likely to demand 20% or higher premium over face value, the repurchase option could be very expensive--and difficult to sell on Capitol Hill.

Beyond the expense, however, is a political roadblock. President Clinton's pledge to "save Social Security first" precludes using a large chunk of the budget surplus to pay down the $5.7 trillion national debt until the White House and Congress agree on a Social Security reform plan.

Youngdahl, a former colleague of Rubin's, thinks he has a way to avoid both problems: ask Congress to eliminate the government accounting rule that makes debt retirement so expensive, and that requires dipping into the walled-off budget surplus. Under his plan, holders of old debt could tender their securities to the government at so-called reverse auctions. The Goldman economist sees debt repurchases as the best choice because he thinks they would both lower long-term interest costs and increase the efficiency of the U.S. bond market.

Youngdahl warns, however, that such buybacks would need to be protected from politicians who might seek to schedule them at election time, and thus gain from the temporary economic boost that a repurchase would provide.

While no action has been taken yet, Gary Gensler, Treasury's assistant secretary for financial markets, said at a February press conference that the agency is "looking at the mechanics of a debt buyback." A spokesman says the Treasury is still studying the idea.

Of course, Rubin could have worse problems. The bond market's travails are great news for the economy. A shrinking supply of government bonds pushes up demand, which in turn lowers yields. That's good for interest rate-sensitive sectors of the economy, such as housing and autos.

Less government debt also will lengthen the life span of the expansion. "Don't you feel better when you don't owe anything on your credit card? It's the same idea," says Alan Day, economist at Stratevest Group, based in Burlington, Vt. But as the federal government cleans up its balance sheet, Rubin and everyone else who cares about the health of the bond market will have to remember that, in many ways, we may have too much of a good thing.

Before it's here, it's on the Bloomberg Terminal.