How Bonds Could Fund the Deficit

The incoming Obama Administration and its acolytes in Congress have floated various trial balloons regarding the size of the next stimulus package. Most of the press reports on the topic place the size of the package at something in the neighborhood of $750 billion. That is an enormous sum of money and will place significant stress on the capital markets.

I think that the Treasury will be hard pressed to raise that amount of money without some novel financing ideas. In my opinion, the amount to be financed is so massive that I think that they will raise the preponderance of the money in the coupon market rather than the bill market. This bill is so large that they will not relish the prospect of facing continuous roll overs for this new round of debt.

That raises the new and troubling question of how to raise that much money. Existing issue sizes are already large. The most recent 2 year and 5 year duet raised $38 billion and $28 billion, respectively.

The new monthly 3 year note raised $25 billion at its debut in November but was quickly bumped to $28 billion in December.

At the November refunding announcement the Treasury announced that they would issue the 10 year note on a monthly basis rather than eight offerings per year as had been the custom previously. The Treasury will announce an issue at each refunding month (February, May, August and November) and then reopen that issue in the following two months. The November 10 year raised $20 billion and the December reopening raised $16 billion. I suspect they will reopen the issue in January for about $12 billion. If you do the math, you will note that in November 2018 when this gargantuan issue matures, the taxpayers will be on the hook for $48 billion.

The bottom line is that the Treasury has squeezed about as much juice from that sector as one could hope to squeeze.

At the November refunding the Treasury returned the 30 year bond to a quarterly cycle. The auction size was $10 billion.

I think that when one manipulates the issues in the current cycle it is difficult to raise the amount of money the Treasury will need without major surgery.

If we make the monthly 2 year note and 5 year note $7 billion larger, that would raise $168 billion.

I guess one could do the same with the three-year note and raise another $84 billion.

As I suggested earlier, I think that the market is already saturated with 10-year note supply and there is little to do there.

Thus far we have tinkered with the current system and raised $252 billion which is well shy of the $750 billion they will need.

I think the first option is a new 7-year note. In the past that issue was always a bit of an orphan child and traded poorly. I think it is a different world now and with the depth of the futures market and the swap market I think that the market would treat a new source of liquidity in the sector quite well. I think the market could absorb $15 billion to $20 billion in this sector. I will call it $200 billion for the purpose of this discussion which means we are still searching for $300 billion.

I think that will force the Treasury to move to monthly 30-year bonds. If they were to do $15 billion in that sector they would raise an additional $140 billion.

The deficit arises from the subprime crisis and the credit crisis which it spawned. The reaction of the Federal Reserve throughout (nearly) has been to attack with novel and radical solutions. I think that if the Treasury has such an option its implementation would serve the taxpayer well.

Rates are hovering near half-century lows. I think that the Treasury should take advantage of the current rate structure and should issue a chunk of 50-year bonds. Issuing these bonds at any rate below 4 percent seems like a steal to me. These are unusual times and Treasury should consider this unusual and unique funding approach.

As an addendum, some may wonder why I have ignored the TIPS market. That market is thin and illiquid and the dealer community has actually suggested that the Treasury refrain from issuing this paper. The dealer community has noted that the bonds do not have significant sponsorship and that corporate issuance of inflation indexed bonds is virtually nil.

I am leaving several interesting links (to me) at the end of this post.

http://www.treas.gov/press/releases/hp1135.htm

http://www.ustreas.gov/offices/domestic-finance/debt-management/adv-com/reports/

http://www.treasurydirect.gov/instit/annceresult/press/press.htm

http://www.treas.gov/offices/domestic-finance/debt-management/auctions/auctions.pdf

Comments

[Dave Wrixon:]

I think you are reaching the point of resistance however you package the debt.

2008 Dec 29 01:51 PM

[Chris B:]

The "dealer community" certainly wishes that there was not an inflation-indexed bond that people could just buy off the government's website, bypassing them and their commissions.

Corporate issuance of inflation-indexed bonds is virtually nil because (a) why would investors not just buy TIPS? (b) upside liability is unlimited, and (c) it looks like such bonds will be yielding more than flat rate bonds.

I would agree with the author that now is the time for the government to lock in low rates long term. When the treasury bubble pops, it will cause massive damage, but we might as well reduce our debt load while we can. Are treasuries callable?!

2008 Dec 29 03:15 PM

[MarvinMBA:]

Buying into any debt at these almost zero interest rates can be very hazardous to your financial health. You are giving money away at todays interest rates and you will be a big loser going forward if you need to cash them in as interest rates rise and they will. So you will get hit two ways...1. Virtually no return on you investment and 2. Loss of capital... Investing today in long term Government or private paper for peanuts is going to be another bubble that will take away your nest egg...MarvinMBA

2008 Dec 29 03:34 PM

[Moon Kil Woong:]

A point to all this is the other side of the coin. At these rates the US government saves loads of cash because they are paying super low interest rates.

The author is right. If they can get as many of these long term Treasuries floated at they can they will be better off in the future (at the cost to the purchasers of course).

2008 Dec 29 09:20 PM

[whidbey:]

Marvin has a point. This is clever only if one believes the government will meet the bonds on due dates with currency that is worth the wait. Why would anyone believe that any fixed rate bond, regardless its due date, will not be rendered useless or worth less via monetizing the federal debt? Say the 50 year is issued at 4% and rises to 24%. So what ? Cheap debt for the Fed just means larger deficits when Congress finds the plan renders spendable funds. Is the risk the currency will be debased faster than the CPI a real risk? Yes, we have had that problem already. The government plays with the inflation rates and we all know that, why would they stop in the future? Why not just get rid of Congressional powers to spend - you know - pay go.????

2008 Dec 29 09:22 PM

[Kunst:]

Why borrow when you can't just print money?

2008 Dec 30 12:53 AM

[Anthony Alfidi:]

That 7-year note sounds interesting. We could get really innovative and introduce notes with maturities of 6, 7, 8, and 9 years, and then bonds that mature at 11, 12, 13, etc. years. Or how about an 8 and a half year note, with a nod to the Fellini movie? ;-) Talk about surrealism.

2008 Dec 30 02:15 AM

[mkreisel:]

The solution is easy: just scare the already scared public into buying US Treasuries. The strategy is already working as Bills have reached 0% for some time now.

2008 Dec 30 03:14 AM

[Guero:]

Isn't the effective rate below 0% now, after commissions?

2008 Dec 30 11:25 AM

[jack kreg:]

if the stimulus is 800 Billion over 2 years or 8 quarters, thats 100 Billion per quarter in borrowing. What happens to the market when the gov/treasury offers that much debt continuously for 2 years.
Not forgetting the ongoing need for the normal budget at 500 Billion per year, hard to believe that treasury's will just sit at current low levels.

2008 Dec 30 12:18 PM