Funding the Deficit

December 29th, 2008 12:25 pm | by John Jansen |

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 of 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 once 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 $7billion 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 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 crises 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 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

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  1. 16 Responses to “Funding the Deficit”

  2. By Kevin Mackey on Dec 29, 2008 | Reply

    Is the more relevant question, “How much is the deficit funding going to cost?” compared to the question of “How are we going to fund the deficit?”

    They both have ties to one another, but in the event that we are forced to turn to monetization, the peripheral effects on the dollar and the cost of inflation, in my opinion, outweigh all other concerns.

    Additionally, why would the government want to issue TIPS right now when they can issue regular bills, notes, and bonds that will cost less to pay back in an inflationary environment? As an investor that would be nice, but as an American, I hope they don’t go down that road.

  3. By cynick on Dec 29, 2008 | Reply

    the 50 year paper is a good idea, though I’m not sure how much appetite exists for it.

  4. By John Jansen on Dec 29, 2008 | Reply

    Kevin,

    As you suggest the question of cost and method go together. Theoretically,they could fund the whole thing near zero if the did it all in bills.

    That would be dumb, obviously.

    I just think this is an unusual time and they should solve with unusual issuance.

    I think it will be quite a while before the ravages of inflation are felt but it will come back with a vengeance.

    So as taxpayer it makes sense to me to lock in as much long money as possible

  5. By Kevin Mackey on Dec 29, 2008 | Reply

    I agree with your last comment regarding the maturity of the debt. That is certainly the smartest thing to do right now.

    While it is impossible to know if/when inflation becomes a major problem, you seem to think it is going to be longer than most; why? Do you think our current problems are enough to eclipse an event that could trigger high inflation quickly such as a flight from the dollar or massive sales of Treasuries by foreign countries? To me those kinds of events would be a backward way with which we could find ourselves in an inflationary environment.

    I understand US debt holders (mainly referring to foreign holders) all have a vested interest in keeping the securities’ values healthy and the dollar relatively strong, but as we have seen in the past couple of months, once investors fear the worst, it can turn into a self-fulfilling prophecy as no one wants to be left holding the bag. Add shorts to the mix and things could get incendiary quickly. I don’t see now being the time where this scenario plays out, but it would be stupid not to be aware of its possibility.

  6. By S on Dec 29, 2008 | Reply

    Jj

    There is a post in Bloomberg today sighting the 9T in funds “on the sidelines.” It is intereting to consider what happens if all that money decides that paper assets have been permanently demoted – this would be the blow off the tiop asset bubble in something that will do more to harm the American people and their standard of living than any deflation. It goes to poster above point of not how to but how much. At some point arguably soon the watershed event occures when the Fed simply loses the bond market.

    Take the editorial in the Japan Times calling for Japan to write off its treasury debt in retrun for infrastructure projects for its companies in the US. See Jesse’s Cafe Americain post. He portrays the problem bluntly – either selective default or dollar destruction. Binary.

    Also do not ignore the trial ballon about foreign currency US debt — an attempt to herd capital flight from the US.

    If the US wanted to send a message they would issue floating rate debt tied not to some make believe index, rather a basket of usable goods. Bit perplexing to hear someone say good for America bad for me as an investor. Shouldn’t they be on in the same.

    Look forward to mandated 401K contributions into the bond market and or spcial demniminated bonds. Desperation.

  7. By John Jansen on Dec 29, 2008 | Reply

    It would seem to be the ultimate bubble.

    What do yo think of the japanese comparison in that Japanese rates stayed very low for a very long period of time.

    Suppose the economy doe not begin to turn and remains solidly in the minus 3 percent to minus 5 percent morass for three or four quarters. Suppose we do not shake the recession until early 2010 rather than mid 2009.

    Would that force the 10 year well through 2 percent.

    That is what some bright people are opining.

  8. By BL on Dec 29, 2008 | Reply

    The trouble with Japan is they mostly live in apartments in the city, and have no place to put stuff or build stuff, or grow stuff. Stimulus doesn’t much matter there.

    America recovered from the Volcker-induced credit crunch in the early 80’s. It will soon recover from this one, because now the Fed is pushing the opposite way, and the Dem’s are going to push huge stimulus, which I expect will focus on wise investments that set the stage for future growth.

    Call me an optimist, but I’ve made a killing on HYG and LQD the past month by having a little faith. Soon time to buy stocks…

    BL

  9. By Michael Krause on Dec 29, 2008 | Reply

    John,

    You are overthinking this. We need more money supply. Thus the source of the funding will be debt monetization.

  10. By K T Cat on Dec 30, 2008 | Reply

    I would only buy long-term bonds in a company or nation that I thought might pay them back. How are the debts from the US government going to be paid back?

    At some point in time, investors will wander off to another country. Even if it isn’t a stampede, it will raise the interest rates the US has to pay on its debt. We’re increasing the debt wildly right now. Interest rate increases later will be murderous. Since you know that will happen at some point in the future, why would you bet on the long-term solvency of such a profligate and irresponsible organization?

    Short term, the US is hard to beat. Long term, not so much.

  11. By Jeff Burke on Dec 30, 2008 | Reply

    The end game becomes end-ier.

    A 50Y bond in 2058 will make a conversation-starting rolling paper, and that’s about all.
    Who in their right mind would buy long term (> than 1 year these days) US$ debt knowing monetization will vaporize the currency?
    Well, China, yes, but they will get fleeced for all their reserves soon enough. Not even they don’t have enough to fund more-of-the-same-thing-that-caused-the-problem-in-the-first-place.

  12. By Kevin Mackey on Dec 30, 2008 | Reply

    I agree with KT’s point, but also agree with John’s point about issuing as much debt as possible now while rates are low and demand is high. What happens in the future is inevitable, just like the country being too involved in the problem right now to stop taking action. At this point, we have to do whatever it takes to complete what we have started for this recession and prepare ourselves for the next bubble to burst and/or the next major financial problem to arise – whatever it may be. I am glad I am not in a financial position with the government…

  13. By K T Cat on Dec 30, 2008 | Reply

    Kevin, if you did that, wouldn’t you run the risk of starting the stampede early? I would think that the first failed auction of Treasuries is going to make a lot of people very nervous. When that happens, some of them will bolt making the next auction even worse.

    This is going to be like handling a poisonous snake. If you move too fast, it will bite you. I think you want to auction as much as you can, but avoid a failed auction at all costs.

  14. By Bond newbie on Dec 31, 2008 | Reply

    I don’t understand why there aren’t more contrarian investors looking at just the real rates for TIPS. Run ILBE on Bloomberg — does anyone really think we’ll average sub-1% total CPI for the next FIVE years? I think prices are “sticky downward,” because deflationary prices => deflationary wages => unhappy Obama voters who all expect a 3%+ raise each year.

    So with real yields on TIPS above 2% and “free” inflation protection relative to nominal Treasuries, TIPS look like a buy for the patient investor.

  15. By Joe on Dec 31, 2008 | Reply

    Newbie, I agree that TIPS are a much better choice than nominal Treasuries for your “patient investor.” To quote Jim Rogers: Why would anyone give money to the United States government for 30 years at three or four percent?

    OTOH, no one knows when the high inflation will arrive, so your contrarian would have to be willing to hold them for an indefinite time period. For traders, that makes TIPS tough. They just aren’t as liquid, which is why their yields look so good compared to T-notes.

    I got a smile when I read John’s original posting (above) saying that some dealers are telling the Treasury not to bother with TIPS. Isn’t that the way it always is? Everyone wanted TIPS 6 months ago, at exactly the wrong time, now everyone spits on them when inflation has hit bottom.

    As long as this thread is still going, may I comment on the original point? I don’t think there is any chance of 50yr. bonds. Irrespective of the logic, the politics of it seem impossible: too many cries about mortgaging our grandchildren’s future.

    If the 30 yr. bonds don’t cover, I expect the introduction of new issues shorter than 30 years. Jan Hatzius put out a nice piece when the TARP was announced, pointing out that the Treasury will need to make some effort to match the duration of the notes to the duration of the TARP assets bought with the note proceeds.

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