More on the same, from the Tidbits thread:
>>>By John M. Berry
Washington Post Staff Writer
Sunday , July 30, 2000 ; H01
Claire P. Goldman, a 77-year-old retiree in Silver Spring, first got annoyed with the U.S. Treasury in March 1998 when it announced that it wasn't going to sell any more of its popular three-year notes.
So she began to buy a different, shorter-term security, the one-year Treasury bill. Then, in February, the Treasury cut back sales of that bill from once a month to once every three months. Now it appears likely to eliminate the bill soon.
"It is going to be very difficult for me," said Goldman, one of the millions of investors around the globe who are being forced to adjust as the world's safest investment – Treasury securities – disappears.
The supply of Treasury securities held outside federal government trust funds – although massive at $3.4 trillion – is shrinking as mounting federal budget surpluses reduce the U.S. government's need to borrow money each year.
As the Treasury issues fewer new notes, bills and bonds, and buys back some others, about $200 billion worth of Treasuries will vanish from the books this year, and most if not all of the remaining supply could be erased over the next 10 years if the surpluses materialize according to government projections.
Treasuries have long been a popular investment, primarily because they are seen as carrying zero risk of default. Because they are safe and easy to trade and were until recently in abundant supply, Treasuries have been used for a wide range of purposes by all types of investors – becoming the grease that keeps the machinery of world financial markets operating smoothly.
Already, the shrinkage in the supply has caused hiccups in the machinery and forced small and big investors alike to look for ways to change their investment strategies.
"It will reduce my income if I have to go through another avenue," said Goldman, who is among the 700,000 individual investors who buy Treasuries directly from the government, attracted in part by the ease with which they can purchase the securities and the lack of fees.
Goldman said she has started buying bank certificates of deposit as a substitute. CDs are federally insured up to $100,000, but CDs cannot be traded in a large and active market.
Bigger investors who will have to find alternatives include the portfolio managers of corporations, banks, mutual funds, pension plans, state and local governments, foreign countries and even the Federal Reserve.
There is no shortage at all of new private securities that can serve as substitutes, but even the best of those carry more risk of default than Treasuries, which is a problem for risk-shy investors.
The safety of Treasuries has attracted hordes of investors when financial crises or regional conflicts have flared around the world. That sort of "flight to safety" occurred on a global scale during the Asian currency crisis that began in 1997 and after the Russian debt default of 1998.
As Treasuries are phased out, various investors will have to find alternatives to use as collateral for loans, for backing of esoteric derivative instruments and for hedging positions taken in other securities.
Financial markets are coping with new uncertainties because they have long depended on all but the shorter-term Treasuries as benchmarks for setting the interest rates of corporate bonds and other financial instruments.
This year will be the third year in a row that federal budget surpluses have caused the government to issue fewer new Treasury securities. The department has even launched a program to buy back from willing sellers older, relatively high-yielding notes and bonds that will retire about $30 billion worth this year. But this new reality seemed to escape most investors and bond traders until just a few months ago, when the Treasury announced it was cutting back both the size and frequency of its auctions of new securities, such as the one-year bill.
Suddenly, Treasury prices shot up and yields dropped significantly on the Treasury's five- and 10-year notes and 30-year bonds. These rates dropped even though the Federal Reserve was raising short-term rates.
As economist Robert V. DiClemente of Salomon Smith Barney in New York put it, the "scarcity value" of the securities became more important in determining long-term yields than the Fed actions.
After the unexpected drop in Treasury yields, the spread between the ultra-safe Treasuries and the relatively more risky private securities became much less meaningful. Treasury yields still are used as benchmarks, but they are less important than they were, and that importance will diminish steadily along with the volume of Treasuries.
Market experts are casting about for alternatives, though there's no consensus on what it will be. Among the options for both individual and institutional investors are AAA-rated corporate bonds and those issued by institutions such as the World Bank. Notes and bonds from "government-sponsored enterprises," such as Fannie Mae, which raises huge amounts of money with which to acquire home mortgages, could fill the bill.
Fannie Mae is seeking to have the yields on its securities become a substitute "benchmark" against which yields on other securities are based. But Fannie Mae is under something of a cloud because the Clinton administration is trying to eliminate its access to direct credit at the Treasury, and Congress is holding hearings on that and other issues related to its future status.
One alternative benchmark is called the swap curve. Like the Treasury yield curve, which shows the current yields of Treasury securities of each maturity, the swap curve is based on deals in which one party, who is paying a fixed interest rate on an obligation but would prefer to pay a variable rate, finds someone who would like to swap a variable-rate obligation for a fixed-rate one. The swap curve shows the fixed-rate side of such deals.
Last week, Ford Motor Co. sold $3 billion worth of five-year securities that were priced at a specified spread above the five-year swap rate.
"Maybe they are looking for a new benchmark that is going to be steady, that may be around for a while," said Michael Maurer of A.G. Edwards & Sons Inc. "There'll always be swaps. . . . Who knows how long five-years [five-year Treasuries] are going to be around?"
When the Treasury announces its borrowing plans early next month for the rest of the year, some analysts expect further cuts in new security issues. Along with the 52-week bill, there is also a chance that the 30-year bond, which has been issued regularly since 1977, will be dropped, analysts at Merrill Lynch & Co. told their clients recently.
Among the most immediately affected of all Treasury holders is the Federal Reserve. As of last week, the nation's central bank held $506 billion worth of Treasuries as the major asset backing the huge amount of U.S. currency circulating in this country and around the world. In recent years, that portfolio has grown an average of 5 percent to 8 percent annually in line with the demand for currency, all of which are officially Federal Reserve notes, as it says on each bill.
So long as the amount of Treasury securities was increasing rapidly, as was the case while the government was running large annual budget deficits, the Fed's acquisition of Treasuries created no problems. But now the central bank is competing with all the other investors for a shrinking pool of securities with the long-term prospect that the Fed will have to make massive changes in what type of assets it holds.
Peter Fisher of the New York Federal Reserve Bank, who is in charge of managing the Fed's portfolio, said recently that the central bank needs an active private-sector market for whatever assets it holds to allow it to manage the portfolio properly.
"If private holdings of Treasury debt go to zero, then our holdings would, too," Fisher said.
The Fed has launched a study to find a long-term solution to this new problem, but it won't be completed anytime soon, Fisher said.
Years ago, the Fed began to shed its holding of Fannie Mae and other "agency" securities, and under the circumstances appears unlikely to choose them to replace Treasuries. The central bank could choose to change its operating procedures and put money into the system directly by lending it to banks, with the bank loans then serving as the collateral for currency. Or it, too, could choose to buy other types of high-quality private securities.
In the meantime, the Fed has adopted some new rules to avoid overwhelming the Treasury market with its constant need to expand its holdings. Essentially, the central bank has put limits on the share of any single new Treasury issue that it will acquire: The Fed will buy no more than 35 percent of any new issue of bills, 25 percent of two-year notes, 20 percent of five-year notes, and 15 percent for 10-year notes and 30-year bonds.
At the end of March, foreigners owned nearly 40 percent of outstanding Treasuries, with foreign official institutions holding more than $600 billion worth and almost $700 billion in private hands.
Officials at both the Treasury and the Federal Reserve have studied whether the shrinkage of available Treasuries is likely to reduce the desire of foreigners to invest in the United States, and both concluded there is no reason to think it will.
That's an important question for two reasons. First, a drop in the flow of foreign capital into this country would make it more difficult to finance the very large deficit the United States has in trade and other transactions with the rest of the world. Second, a drop in that flow could also knock a large hole in the value of the dollar, which would make imports more costly and possibly make inflation worse.
As one government official argued, it seems unlikely that a development that strengthens the fiscal position of the U.S. government – namely paying down the debt – would make foreigners decide to invest elsewhere just because Treasury securities were no longer as available as in the past.
One potential future difficulty that apparently no one has an answer for is what could replace the roughly $250 billion worth of Treasury securities owned by state and local governments. The governments are required to buy these securities, which cannot be traded, when they issue tax-exempt bonds to build roads, schools and other facilities if the proceeds aren't used immediately. The tax-exempt bonds carry much lower yields than taxable bonds, with the federal government subsidizing the state and local governments by forgoing the tax revenue it otherwise would collect. If the other governments were allowed to park unused money from tax-exempt bonds in taxable bonds, they could make enormous amounts of money – at Treasury's expense – on the difference in yields.
Even the U.S. government would have to manage its finances differently without a debt to absorb the effect of the huge variations in tax receipts from year to year. Currently, the government varies the size and frequency of its debt issues according to its cash position. If there were no debt, Treasury's options would include letting the cash pile up, investing it in private-sector securities and cutting taxes.
Even the future of an American symbol of thrift, the venerable U.S. savings bond – a form of Treasury security – would be in doubt if there were no debt.
All these dislocations caused by the disappearance of Treasuries raises the question of whether it might be better for the government not to pay off the entire publicly held debt. It could maintain some supply of Treasuries while using part of the budget surpluses in other ways.
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