Geithner Gone Wild: Treasury Entertains 100 Year and GDP-Linked Bonds to Fill New $2.4 Trillion Demand

Each quarter, we break down the minutes of the Treasury Borrowing Advisory Committee (TBAC) meeting where primary dealers and other members of the investment industry advise various members of the Treasury what the market will bear in terms of debt issuance. There are usually more than a few interesting tidbits as we learn just what's on the mind of those in the business of buying Treasury coupons, holding them for two weeks, and selling them to the Federal Reserve at a higher price. And because the Federal Reserve viz a viz its System Open Market Account (SOMA) is the largest holder of Treasury debt, none other than its two managers, Brian Sack and Joshua Frost, were present as representatives of the world's largest central bank cum [unhedged] hedge fund. The current minutes are shorter than usual, but worth reading as they reveal an emboldened, opportunistic Treasury looking forward to novel ways to fill an ever expanding appetite for US debt, which is all but guaranteed as a result of new, socialized banking regulations.

As we have long speculated, Basel III is nothing more than an elaborate mechanism for artificially increasing demand for sovereign debt and globalizing banking regulation. Indeed, the minutes of the prior TBAC meeting revealed that new regulations aimed at "reducing banks' risk profile" are expected to generate at least $400 billion in increased US Treasury debt alone by 2015. However, this estimate has now exploded and has Treasury salivating (emph. ours):

The member recommended that Treasury develop products that target the needs of three different investor classes, specifically banks, pension funds/insurers, and retail investors. The member estimated that demand from these three investor classes could total $2.4 trillion over the next 5-years, if the right products were offered.

And just where is this new demand coming from? Why, the very markets that have imploded are are teetering on implosion thanks, in no part, to the actions of the central planners:

On the supply side, opportunities to expand the investor base have developed due to market dislocations following the financial crisis. A decline in GSE debt issuance, the wind-down of bank debt issued under the Temporary Liquidity Guarantee Program (TLGP), dislocation in the municipal market, and the contraction of the commercial paper market have resulted in a shortage of high quality assets.

For further evidence that Treasury lusts to crowd out private investment (or is it "crowding in", as Paul Krugman hallucinates--paging Bob Murphy) and become the #1 investment in its citizens' portfolios:

Expanding the Treasury investor base to include more domestic investors by offering new products is desirable and would reduce overall funding risk. The presenting member noted that other sovereigns’ debt (Italy, Japan, and the UK) is largely funded by domestic investors. The member further noted that it was important to avoid cannibalizing the current auction process and that any new products should add to demand.

A dazzling array of "solutions" are then presented to fill the engineered void, in which we find 40, 50 even 100 year bonds, callable coupons, floating rate bills (to reduce rollover risk) and even GDP-linked bonds (because the BLS is so spot-on):

The presentation next discussed a variety of specific securities and debt management techniques that could potentially aid Treasury in achieving its goal of expanding the investor base and financing the government at the lowest cost over time.

The presenting member first discussed “ultra-long” bond issuance, which were defined as securities issued with a tenor of 40-, 50- and/or 100-years. The member noted significant demand exists for high-quality, long-duration bonds from entities with longer-dated liabilities. It was noted that duration tapers off rapidly with maturity and is dependent on the underlying coupon on the bond. As a result, liability-driven investors would likely use the STRIPS market to capture additional duration exposure.

The presenting member then discussed increasing the U.S. Treasury investor base through callable issuance. The presenter noted the emerging gap between demand and supply in this market, driven by less GSE callable debt and MBS issuance. The member added that Treasuries are a relatively close substitute for Agencies, especially in the 2- to 5-year maturity ranges with 6-month to 1-year lock outs. According to the member, accounts that buy callable product include domestic banks, foreign banks, state and local governments, fund managers, insurance companies, pension funds and foreign investors. The presenting member noted that demand may exist for longer-maturity callable paper. This space is currently occupied by corporate names carrying ratings of BBB or lower.

Examining current pricing for Agency product, the presenter estimated it would cost Treasury an additional 18 basis points to issue a 5-year bond callable in 1-year and an additional 8 basis points to issue a 2-year bond callable in 6-months.

While this strategy would give the Treasury additional optionality in managing its debt and potentially increase its investor base, the presenting member remarked that demand for callable product tends to decrease if investors expect interest rates to increase. If market volatility increased or we entered a rising rate environment, the member mentioned that the Treasury would have to offer higher yield enhancements to maintain a regular issuance program.

The discussion then turned to potential demand for new money market instruments. The presenter concluded that new regulations may be creating room for increased bill and callable issuance to fill the emerging gap between Money Market Mutual Funds and issuers. Regarding bonds targeted for individual investors, the member concluded that increasing household ownership of Treasuries has the potential to broaden the investor base significantly.

The discussion turned to floating rate securities with short-dated reference rates such as bonds indexed to the 6-month T-bill rate with a semiannual reset. While such instruments would not protect Treasury against increased debt service costs in a rising rate environment, they would reduce rollover risks. CMT-style floaters, which have a reference rate that is generally on a maturity much longer than the reset period, have had mixed success in other countries due to the complexity of pricing.

GDP-linked bonds were noted to be an interesting product for which more research needs to be done to assess their potential. A discussion ensued about the possible increased demand for TIPS from separating the final cash flow of TIPS into the unadjusted principal and the inflation accrual components in order to create a “pure inflation” component.

The meeting apparently ended with animal spirits getting the best of those in attendance:

An energetic discussion followed regarding the merits of different debt instruments discussed in the presentation. The committee concluded that this topic deserved further review.

Full minutes may be found here.