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Commentary
One
more repo and I'll be debt free. – Anonymous Bumper
Sticker
Déjà vu All Over Again?
Four
short years ago, the U.S. Treasury, awash in a forecast surplus position
and citing unnecessary costs, ceased new sales of 30-year bonds. At that
time, the “long-bond” constituted 21% of overall
Treasury debt and the average maturity of issued debt approximated seven
years. Since October 2001, much has changed. The average maturity of
issued debt is now approximately five years, and a budget deficit is
forecast to persist well into the future.
Last week, the Treasury Department announced that it is considering
a revival of regular long-bond issuance. Should the proposal move forward,
a likely scenario would call for semi-annual sales of between $20 billion
and $30 billion in 30-year maturities.
What’s behind the revivalist movement? Not surprisingly, Treasury
officials are citing:
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The benefits of borrowing-cost diversification. |
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Increased global issuance of longer-term debt (e.g.,
recent and pending issuance of 50-year government debt by France
and the U.K.) |
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Newly proposed Department of Labor pension
rules that would require funds to measure the market value of assets
against the yields on long-term debt. |
Still, cynics might wonder if the about face might be a tacit admission
that sizeable deficits are here to stay. Or, is the Treasury more closely
monitoring implied forward interest rates (similar to the What Counts Optimality
Index) that continue to indicate that the long-end of the yield curve
remains the best area to borrow?
What are the implications of a potential re-opening of the long bond?
Additional supply of longer-term debt could provide some impetus for
yield curve steepening. This could be an important development, as
many recent simulations conducted by the Seattle Bank’s Financial
Advisory Services team have shown that the forecast results of financial
institutions are impacted more severely by flattening of the yield curve
than by large parallel interest-rate shocks. Additional supply of debt
is already increasingly directed to the longer end of the
yield curve. This week’s
refunding calls for $5 billion more of 10-year securities than were
issued at the previous sale. At the same time, recent issuance of 3-year
and 5-year securities has remained the same.
A final decision on the potential revival of the long-bond is expected
by August.
As long as we’re on the subject of “back-to-the-future,” the
fixed-income market has recently appeared to focus exclusively on market
data that point either to an up-tick in the inflation rate, or an economic
soft patch, depending upon the day of the week. Could we be revisiting
the mid-to late-seventies, when the economy had the worst
of both worlds: oil-induced inflation and slow economic growth? Let’s
take inventory.
Although benign by historical standards, inflation has unquestionably
shown signs of life. Oil prices have averaged above the $50 benchmark
for over four months. The Commodity Research Bureau's future price index
is now approximately 85% higher than its recent low watermark in 2001.
Housing, health care, and education costs also continue to escalate.
The personal-consumption
expenditures price index, a measure closely watched by the Federal Reserve,
increased at an annualized rate of 2.2% during the first quarter. This
represents the fastest rate of growth since late 2001. With a continued “measured” pace
of tightening, the Fed appears to view these inflationary pressures as
consistent with a normal economic expansion and not necessarily a deeply
embedded phenomenon. What’s likely to hold the lid? Productivity
increases and the competitive forces unleashed by technology and globalization.
Nonetheless, as depicted in Figure 2, it appears that the edge of productivity
growth relative to labor costs is waning.
Figure 1. Year-over-Year Growth: Non-Farm Sector Output Per Hour vs.
Unit Labor Costs
GDP continues to expand, albeit at a slower rate. First quarter GDP
registered an annual growth rate of 3.1%, significantly below the market’s
anticipated rate of 3.5%. Reduced spending growth on capital equipment,
inventory build-up, and the yawning trade deficit appeared to be the
chief culprits. This month’s What Counts Select
Forecasts of Key Economic Statitics predicts respective GDP growth
rates of 3.1% and 3.3% for the second and third quarters—a sizeable
decrease from last month’s
forecast. On the flip side, the Labor Department announced that employers
added 274,000 workers during April. This increase was 100,000 higher
than expected. Payroll additions for February and March were also revised
upward by 93,000. For the first four months of 2005, payroll increases
have averaged 211,000 jobs per month. That’s not too far off the
average of 238,000 that took place over the period of expansive growth
from 1996 to 2000.
So, is stagflation once again rearing its ugly head? If we focus on
current fundamental trends, not likely. Oil is less important to the
U.S. economy; over the past 30 years, although energy consumption increased
by 30%, the U.S. economy’s constant dollar rate of growth was 140%.
Jobs are being created at a pace that is representative of a moderately
expanding economy. Global competition is containing prices at the finished
goods level.
Nonetheless, we can’t deny the event risks that may cloud the
outlook: continued trade and budget imbalances, a persistently low savings
rate, consumers who may no longer enjoy the benefits of cash-out refinancings,
and tax cuts, currency uncertainties, and an oil shock (e.g., Goldman
Sach’s recent scenario of a “super spike” in commodity
prices, including an oil price that could eventually surpass $100 a barrel).
Figure 2. University of Michigan Consumer Confidence Index vs. Brent Crude
Spot Price
Mind the Gaffe
When the long-awaited release of the Federal Reserve’s
Open Market Committee minutes from March were released last week, the
financial world’s
dialecticians and grammarians were quick to notice the absence of seven
key words that had been included in previous releases: “Longer-term
inflation expectations remain well contained.” The bond market
interpreted the omission as a sign that the Fed had heightened its worries
over inflation and immediately boosted the yield on the one-year note
by seven basis points. One hour and 39 minutes later, the seven words
were reinstated into the release, and yields declined to their earlier
intra-day levels.
Aside from the dramatic omission and subsequent retraction regarding
longer-term inflation prospects, the Fed did note that “pressures
on inflation have picked up in recent months and pricing power is more
evident.”
Market sentiment calls for further “measured” increases
in the fed funds rate. Per the What Counts monthly forecast,
consensus calls for a year-end fed funds rate of 3.92%, rising to 4.21%
by mid-2006. Projections for 10-year yields for the same time frame don’t
stray too far from today’s levels. These observations,
along with the implied forward swap yield curve seem to suggest that
if you stare long enough at the flattening yield curve, you just might
see the back of your head!
Figure 3. IMM Eurodollar and Term Fed Funds Yields – 5/10/05
Figure 4. Current vs. Implied Forward Yield Curves
John Biestman is assistant vice president, IMS consultative
sales advisor at the Federal Home Loan Bank of Seattle.
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