A world without a U.S. Treasury market? That was unimaginable a few years ago, when budget deficits stretched as far as the eye could see. But with the recent rise of the government surplus, the unthinkable no longer seems beyond the pale.
Many traders and analysts, expecting the White House and Congress to give away most future surpluses through tax cuts and spending, still consider the Treasury market's demise unlikely.
But because the projected surpluses are large and have a momentum of their own, it could happen here a lot faster than many think.
The United States has been borrowing to make ends meet since the nation was born, especially during wartime. But the Treasury market as we know it today did not take shape until the mid-1970s, when government deficits soared in the wake of a severe recession and rising oil prices. The wild volatility of interest rates late in the decade and into the 1980s focused intense attention on the bond market.
That spawned the growth of a Wall Street infrastructure, fostered the bond-trading "masters of the universe" of "Bonfire of the Vanities" fame, and made the Treasury market the benchmark for the world's bond markets, a haven for cautious investors around the globe.
Already, however, the trusty 30-year bond is threatened with retirement — that is the recommendation of a Treasury advisory group. The last one-year Treasury bill was issued in February, and inflation-indexed bonds are on the chopping block.
What is pressing even more relentlessly against the Treasury market's viability is the expected size of budget surpluses compared with the debt maturing each year. When the surplus exceeds the amount of old Treasury notes and bonds maturing, the government has no need to raise more cash to operate. So it will have a hard time arguing that it needs to keep selling new securities, including the 10-year note, which has already replaced the 30-year bond as the benchmark.
And barring big surprises, the date when the government faces this issue is not far away. Based on current forecasts, including approval of President Bush's $1.6 trillion, 10-year tax cut, the surplus would exceed the total of maturing debt, including the cost of debt buybacks, in less than five years.
A mild recession would not delay that, according to the Congressional Budget Office's official projections. It is true that an accelerated tax cut and a sharper economic slowdown would reduce the Bush administration's anticipated surpluses significantly. But even that might put the date off only a year or two.
Pinning it down precisely is not possible because the date depends not only on the economy and budget decisions, but also on policy decisions by Treasury Department on how fast to curb the issuance of new debt.
At the end of fiscal year 2005, there could be just over $2 trillion in publicly held Treasury debt, so it would still be traded. But without new issues — and many traders say new issues are the market's lifeblood — the market may just be on life support.
"A big part of what makes a market function well is the infusion of new debt," said John Youngdahl, a senior economist at Goldman Sachs.
Thus, well before all the publicly held debt is paid off, there may need to be a new touchstone for the rest of the fixed-income markets. The pricing of corporate, agency, mortgage and other asset-backed bonds will have to start elsewhere. The usual hedging to reduce risk will have to be done with other securities. And new benchmarks will have to be found. All these functions will have to be performed without the unique character of Treasuries: They are risk-free.
The Treasury market has been the safest place for conservative investors for years. Without Treasuries, investors will have to scramble for alternatives.
Most important, there would no Treasury safe harbor for investors to flee to in a crisis — there are few other choices due to the sharp fall in triple A and double A-rated firms in the past 30 years.
All this leaves the new Bush Treasury Department with major decisions to make, including the immediate fate of the 30-year bond. Treasury Secretary Paul O'Neill could decide to let nature take its course, or he could try to keep the market working by continuing to issue new debt, even though it might not be necessary. One way to do this would be to create an exchange program, in which new debt is issued only in exchange for existing debt, so the total outstanding does not increase. Issuing more shorter-term debt would delay the point at which the surplus becomes larger than the total of maturing Treasury notes and bonds.
Looming over this whole debate are the forecasts, by the Congressional Budget Office and others, that deficits are likely to return as the retirement of the baby boomers gets into full swing in the late 2020s, straining the Social Security and Medicare systems. At that point, again barring big surprises, government borrowing — and the Treasury market — would be back.
Many analysts and traders say the added cost of restarting the Treasury market would be much less than the cost of keeping it alive when not needed. It would be easy to restart, they argue, and is not the be-all and end-all that some believe. After all, the 30-year bond has been regularly issued only since 1977, and the world lived without it quite well before that.
The signs of adjustment are everywhere.
The last outstanding three-year Treasury note matures in May. There have been sharp reductions in other Treasury securities, including the 10-year, 5-year and 2-year notes. Since 1996, annual issuance of new debt has fallen nearly 50 percent to $331 billion in fiscal year 2000.
When the Fed cut short-term interest rates in January, the first to follow its lead was the interest-rate swaps market — where investors exchange fixed-rate debt for variable-rate debt — not the Treasury market. In fact, the yield on 10-year swaps fell further than on the 10-year Treasury note.
Issuance of new debt by Fannie Mae and Freddie Mac — government-sponsored agencies that package home mortgages in bonds that are considered very safe but which are not backed by the full faith-and-credit of the government — is skyrocketing as they move to become the new interest-rate benchmark.
The Bond Market Association has approved guidelines for a when-issued market — once reserved for Treasuries — for these government agency securities so there can be trading between the time a new issue is announced and the settlement date after the auction.
The Fed, which has operated through the Treasury market to move interest rates, is broadening the list of non-Treasury securities it will accept in this process. Candidates include certain state debt and the debt of foreign governments.
Traders at some Wall Street firms say that as much as 90 percent of the hedging of risk they see in the fixed-income market is now done with interest-rate swaps.
And the role of the Treasury market in key indexes of the fixed-income market is shrinking. At its peak in early 1986, the Treasury bond market was 50 percent of the Lehman Brothers aggregate bond index. It is now 26 percent, behind mortgages at 35 percent and soon to slip to third behind the corporate bond market.
James R. Capra, president of Capra Asset Management and chairman of the Treasury Department's Wall Street advisory committee, put the situation more personally. "I am going to be out of business if I am only in Treasuries. The situation is moving inexorably in that direction."
But the fight to save the Treasury market is in full swing. A Bond Market Association committee, separate from the one advising the Treasury Department, is recommending Treasury exchange programs to keep the market functioning effectively as long as possible. This could prolong the useful life not only of the 30-year bond but also of the 10-year note.
Even with outstanding debt at a low level, "it behooves the treasury to keep issuing new debt with an exchange," said Charles Parkhurst, managing director for government bond trading at Salomon Smith Barney.
But when asked if the market will function well this way or be on life support, he replied: "You are not going to know until you get there."
Gary Gensler, the Treasury Department official who oversaw the government debt markets during the Clinton administration, said he still believes "there will be a viable Treasury market throughout all this period because the United States government will be a safer yet smaller and stronger borrower."
Yet he acknowledges that the market will cease to play three of its traditional roles. "Other securities," he said, "will come to be relied on as pricing vehicles, hedging vehicles and benchmarks."
In the end, the future is in the hands of Treasury Department officials. And what they do depends a lot on how they balance the main goals of managing a government bond market: finance the federal government, do it at the lowest cost, and promote efficient capital markets.
Will these add up to keeping the Treasury market alive just because the public has had one it liked for 25 years? Stay tuned.