While the largely impervious longer-dated 10-yr note has remained essentially unchanged during the past year despite raising inflationary pressures, the shortest end of the curve, the Fed funds rate, has seen its yield increase 125 basis points. Of course this class is controlled by the Federal Reserve, by which we view its yield (Fed funds rate) as an indicator of where the widely watched bond Northstar – the 10-yr note – is headed. Unfortunately, foreign central bank intervention has produced a massive structural skew, leaving the relationship between the Fed funds/10-yr note a highly dubious one. So, if the short-end/long-end relationship is lost due to a FCB-dominated 10-yr note, and FCB’s are essentially buying securities throughout the yield curve, then the Fed funds rate is the last standing “honest” guide along the interest rate spectrum. It’s crucial to go further and add that the short-end of the curve is gaining, and should possibly be given more, importance than the longer dated 10-yr note. I point to two important pieces that give this idea some merit – one by Nouriel Roubini and the other by PIMCO's Bill Gross.
According to Roubini, in a superb piece on liquidity/rollover risk on U.S assets, in recent years the U.S has substantially decreased the average maturity of government debt:
“We also know, from official Treasury data that the average maturity of US government bonds has sharply fallen in the last few years. In the late 1990s, when our budget deficits were turning into surpluses, the average maturity of issuance of Treasuries (i.e. the marginal maturity of newly issued debt) went up from about 50 months in 1994 to almost 90 months in 1999; and the average maturity of the total stock of debt thus increased from about 60 months in 1994 to about 70 months in 2000. But since 2000, things have radically changed: the average maturity of issuance fell from 90 months in 1999 to about 25 months by the end of 2002 to then recover only very modestly to 34.2 by September 2004 (a much lower figure than its value in the 1970s, 1980s and 1990s) while the average maturity of the total debt has fallen from about 70 months in 2000 to only 55.1 in September 2004.
How to explain such a sharp fall in the average maturity of the US government debt? Of course, with the sharp fall in short-term rates relative to long-term rates in 2001-2003, Treasury found it cheaper to finance itself short term rather than long term. But of course, if the expectations hypothesis holds, there is no free lunch here as long rates reflect expectations of future movements in short rates. More seriously, Treasury has tried to limit the short run fiscal costs of the growing budget deficit by reducing the maturity, and thus the interest bill, of government debt. But, as the experience of Mexico in 1994 suggest, this is a dangerous debt management strategy: issuing lots of cheap short-term debt may seem a bargain but if a rollover crisis then does occur serious trouble can ensue.
Also, it is clear that one of the main reasons for the shortening of the US debt maturity is given by the identity and preference of the holders of this debt: since foreign central banks prefer to hold short-dated maturities in part because short term debt can be disposed of more quickly when necessity or preferences so require, the US Treasury has had to oblige and provide the assets, short dated T-bills, most preferred by foreign investors. Note also that (based on Treasury data), by now 51% of all US government debt is held by foreigners and at least 29% of all US foreign debt is held by foreign central banks. These figures are very large and historical highs for the US.”
In an April 2002 Investment Outlook (unfortunetly taken off the archives), fresh off a tiff with General Electric regarding their Aaa debt rating, Gross dwells into the corporate practice of using interest rate swaps to term out long-term debt while paying interest payments at commercial paper rates – something GE’s chief Immelt admitted was a practice used at GE following Gross’ comments on GE debt.
“The fresh idea (although it’s been lying in the grass for years now) was that if lots of corporations were doing the same thing, then the short-term Fed Funds rate is driving the economy. Now that of course is no brilliant observation, it has been thus for eight decades or so with a temporary disconnect in the 1940s for wartime finance. But when a creation of the last 10 years – the interest rate swap – makes it possible for Corporate America to term out their debt and still pay near commercial paper rates, then that’s a revelation – or better yet, a revolution. It means that short-term rates are even more critical to the profitability of Corporate America – to the level of the stock market - to the growth rate of the American economy than ever before. It means that Alan Greenspan dare not raise interest rates too much or risk sinking the stock market and the economy once again; it means that because his ability to raise short rates is limited, that ultimately inflation may be higher than it otherwise would be in a still near deflationary world; it means that bond investors should do certain things and not do others.”
At the time of this piece (April 2002), worldwide swaps outstanding totaled $43 trillion. According to ISDA estimates, at mid-year 2004, interest rate derivatives which include interest rate swaps and options and cross-currency interest rate swaps totaled $164.49, leaving the possibility of many more corporations having swapped long-term debt back into short-term floating rate paper.
Gross goes on to add: “The dampening influence which permits corporate interest expense as a percentage of cash flow to appear so benign in Chart 2 has got to have come from lower short, not long rates, which in turn have resulted from large amounts of commercial paper/bank debt/ or – which is the hidden link - long-term debt “swapped” back into floating. Corporate interest expense truly does appear to be “de minimus” and probably because of swapped liabilities into the front-end of the yield curve.”
Bottom line: the Fed funds rate is the last “honest” rate along the yield curve and should thus be given all the more importance. Secondly, because of this and the various other reason pointed out above, one should question the saliency of today’s 10-yr note and the influence it has on the balance sheet of both the U.S government and Corporate America compared to its shorter-dated counterparts – especially on a liability basis. The Fed has started the deleveraging cycle, with or without the 10-yr note. This could present a big surprise to those that view the low rate on the 10-yr note as a temporary reprieve for a highly-levered U.S economy.
--UK
Very nice. Very nice indeed. The only problem is that we at the Fed give little credibility to the aggregate data on debt. The distirbution of debt is what matters and this is an internal study that we have not made public as you guys on the street would be over informed as to the outcome of monetary policy. I mention this in a speach last year but clearly the markets have missed this point. On top of the distribution of debt by households the distribution by corporates is not that bad as well as their ability to service this debt is much much better than you think. Good analysis but at the end of the day PIMCO and the street are wrong to worry about the deleveraging worry is overblown and overdone. <3489264>
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