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A Surplus Of Confusion
The United States Treasury sold its first 30-year bond in 1977.
During the last twenty-three years, debt market dealers, traders, and salespeople have many times each day phoned their offices, or shouted across a room, "Where is it?" The lowest level staffer in these firms has known that "it" referred to the most recently auctioned 30-year U.S. Treasury bond, a.k.a. "the long bond," and "where" referred to its yield and price.
Since roughly February 1st, three weeks ago, the long bond is no more. They are still out there, sure -- billions of 'em -- but the Treasury will sell fewer and fewer new ones, and beginning late this spring will begin to buy back most of the old ones. Your budget surplus at work: the Treasury is buried in cash, and buying back old U.S. Treasury IOU's is the current plan to use the cash.
The buy-back announcement has caused a confused scramble for the remaining bonds, and distorted an interest rate structure which had been reliable for a generation. Generally, life is better when the financial markets are not confused.
I don't know which aspect of this situation is more astounding: the politics or the impact on the financial markets.
In any other era in the history of the Republic, a big surplus would be resolved by giving the money back to the people in a tax cut. Not now, though; only time-warped Reaganites believe in that sort of thing. Fortunately, this bizarre national consensus opposed to a tax cut is equally opposed to spending the surplus.
A large majority of Americans think it's a good idea to tax themselves to the eyeballs, save the revenue for Social Security and Medicare, and to use anything left over to "pay off the national debt."
There was a trial balloon there for a while to turn the Treasury into a stock market investor, wagering the Baby Boomers' Social Security money. That one looks as though it's been shot down for good, thank heavens.
If we're not going to give the money back, not going to spend it, and not going to invest it... that's it: we're going to "pay off national debt." Paying it down a ways is more likely, until we get in some new budget crack. There's just too much out there to pay off altogether: $3.5 trillion in publicly-traded national debt, and another two trillion we owe ourselves (don't ask).
Paying down the debt will be a good thing, as the interest payments are certainly a budget burden. Politicians are already eager to, er... re-deploy as much as $200 billion per year in used-to-be-interest payments.
However, oddly, the debt has been a helpful and clarifying influence on the financial markets. The following is the short story of the peculiar usefulness of the American national debt.
Our national debt is embodied in outstanding Treasury bills, notes, and bonds. Since before World War II American IOU's have been considered the highest quality IOU's (least likely to go into default) issued by any borrower on the planet -- individual, corporate, municipal, or national.
By the last quarter of the 20th century, American Treasury IOU's were considered to have zero chance of default, and the interest rate on American Treasurys has defined the "risk-free" cost of capital. Some nations periodically pay a lower interest rate on their IOU's (Germany, Japan, Switzerland) but that is a reflection of anti-inflation policies, not risk of default.
Debt markets -- all markets for IOU's of any kind anywhere on earth -- have used American Treasurys as the benchmark for pricing every other kind of IOU. The higher the risk relative to zero-risk Treasurys, then the wider the inflation-adjusted interest rate spread over Treasurys.
A second unique characteristic of American IOU's is their liquidity, hence their ease of purchase and sale with negligible bid-to-offer spread. Liquidity reflects quality, but also supply: the enormous volume of American IOU's in circulation has meant less price/yield distortion from temporary supply/demand imbalances.
A third feature of our debt: long bonds were the proxy by which the markets voted on the prospects for future inflation. Even the Federal Reserve watched the long bond as an indicator of whether its monetary policy was too tight or too easy.
As of this month, long Treasurys are no longer useful as a benchmark. In just the last three weeks, pending scarcity drove the 30-year yield down from 6.75% to 5.94%, back up to 6.44%, and now to 6.25% -- all completely unhinged from the economics of any other IOU's anywhere.
Now, in the future... what benchmark should the markets use to price a Disney bond? Or mortgage rates, which have moved in lockstep with Treasury bonds ever since securitization replaced Savings and Loans... what do we use now? What instrument will replace the long bond as the key indicator of inflation fears?
For the time being, markets are watching five- and ten-year Treasurys, but it's a tentative exercise.
Paying down the Treasury's IOU's is a good thing, but tentative markets express their uncertainty in rather greater back-and-forth lurching until they figure things out.
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