Financial Market Implications of the Federal Debt Paydown

The United States achieved its third consecutive federal budget surplus—a record $237 billion—in fiscal 2000.¹ This string of surpluses has allowed the Treasury Department to begin to pay off the national debt. After more than tripling from the early 1980s to the mid-1990s, outstanding marketable U.S. Treasury securities fell from just under $3.5 trillion in March 1998 to $3.0 trillion in July 2000. The Office of Management and Budget (OMB) projects that the surpluses will continue, causing the debt held by the public to be fully redeemed by 2012.²

Although a remarkable achievement, the paydown of the debt also raises some concerns. U.S. Treasury securities play a central role in the implementation of monetary policy and in the efficient working of financial markets more broadly. By reducing and possibly someday eliminating the stock of these securities, the debt paydown raises questions about how monetary policy will be conducted in the future and how financial markets will adapt to the diminished supply of this key instrument. The Treasury's introduction of a debt buyback program in January 2000 and the striking inversion of the Treasury yield curve this year have heightened interest in these questions and spurred discussion as to which assets might be suitable Treasury substitutes.

Treasury securities play several critical roles in financial markets. Because these securities are considered free from default risk and are highly liquid across a wide range of issues, their yields are used as a proxy for risk-free interest rates. These properties, together with the presence of well-developed derivatives markets in which investors can sell Treasuries short, make them a useful reference benchmark and hedging instrument for other fixed-income securities. Their creditworthiness and liquidity also make Treasury securities a popular reserve asset for numerous financial institutions and the primary asset of the Federal Reserve.

Some of the very features that make Treasury securities an attractive benchmark and reserve asset are likely to be adversely affected by the debt paydown. In fact, recent events suggest that the reduced supply of Treasuries may already be disrupting the market and that more such disruptions may be in the offing. In February 2000, for example, the Treasury announced that its one-year bill would henceforth be issued only every thirteen weeks rather than every four weeks. As the last bill auctioned on the old cycle aged, the bill became very expensive to borrow in the market for repurchase agreements (repos). On May 31, for instance, dealers had to lend out funds at a very low 2.25 percent annual rate in order to secure the one-year bill as collateral. The liquidity of the issue in the cash market also suffered, with bid-ask spreads widening and trading volume plunging. At the same time, the issue became extremely expensive relative to other Treasuries of similar maturity.

With the debt paydown under way, market participants are already moving away from Treasury securities as a reference benchmark and hedging device and toward the debt securities of government-sponsored enterprises (such as Fannie Mae) and state-chartered corporations, and toward interest rate swaps.³ These other instruments are liquid (although not as liquid as Treasuries), the debt securities can be borrowed in reasonably active repo markets, and a futures market was recently introduced for agency securities (and is being discussed for corporate securities). Furthermore, the credit risk in these instruments actually makes them potentially better hedging vehicles than Treasuries, because it can result in them trading at prices that track more closely those of other fixed-income securities that also have credit risk. Agency securities and swaps, in particular, are increasingly used to hedge positions, price new securities, and evaluate existing securities in U.S. fixed-income markets.

The Federal Reserve System has meanwhile taken several measures to adapt its conduct of monetary policy to the debt paydown. At its March 2000 meeting, the Federal Open Market Committee (FOMC) endorsed a "broad-gauge" study of the issues associated with changes in the system's asset allocation.⁴ It also disclosed that, until that...