## _wp0161

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### Shrinking Supply of U.S. Treasuries: causes and magnitudes
- "Uncommitted funds" will accumulate in the Treasury because certain securities are not available for early redemption and secondary-market buybacks are limited.
- Projected "on-budget" surpluses contribute to excess cash reserves: Congressional Budget Office estimates put these excess cash reserves at $3.2 trillion by 2011.
- Changes in Treasury issuance policy since the mid-1990s:
  - Between 1996 and mid-2000, the Treasury reduced bill issuance by almost 30 percent.
  - Between 1996 and mid-2000, the Treasury decreased issuance of coupon securities by more than 50 percent.
  - The Treasury stopped issuing one-year bills and three-year notes and cut the number of annual auctions of 30-year bonds from three to two.
- Treasury repurchases:
  - In early 2000 the Treasury began buying back longer-term issues in secondary markets — the first buyback in 70 years.
  - Plans announced in January 2000 involved buying back up to $30 billion (par value) in publicly held debt during the year.
  - The actual amount of buybacks was $30 billion.
  - The Treasury announced plans to buy back another $18 billion in debt during the first half of 2001.
- Outstanding stock and "free float" statistics:
  - Federal government debt is presently about $5.6 trillion.
  - Almost half this amount is held in U.S. Federal, state, and local government accounts.
  - Another 21 percent is owned by the U.S. Federal Reserve Board and foreign official institutions.
  - The "free float" of treasury securities is less than $2 trillion.
  - During 1998-2000, the publicly-held treasury debt fell by $363 billion.
  - The most conservative CBO projection would produce a publicly-held stock of debt equal to just five percent of GDP in ten years; under these projections the free float of treasury securities would disappear within five years.

### Market and official adaptations
- Issuance policy adjustments:
  - Focusing issuance on a few benchmark maturities.
  - Reducing frequency of issuance of some maturities.
- Buybacks and concentrations:
  - Buybacks concentrated on more seasoned, higher-interest debt to offset prior lengthening of maturity.
- Private market adaptations:
  - Market participants have substituted into other dollar financial instruments.
  - The Bond Market Association has advocated maintaining issuance of 30-year treasury bonds to serve investors with rigid long-duration requirements.
- Central bank considerations:
  - Central banks use government securities for monetary policy, foreign-exchange reserves management, and financial stability purposes.
  - The shift into private assets may be interpreted by market participants as tantamount to the Fed underwriting some of the risks associated with the issuing counterparty.
  - This raises questions about the extent to which central banks should systematically incur credit risk and engage in decisions that allocate capital across competing sectors or firms.

### Implications for liquidity, hedging, and safe-haven roles
- Government securities as near-monies and safe havens:
  - At very short maturities, government securities have little market risk and are reliable stores of value; they are widely accepted as collateral and as a medium of exchange for settlements (e.g., Fedwire, Target).
  - The safe-haven role is reinforced by the central bank’s near-monopoly control over the supply of liquidity during extreme market events.
- Consequences of a shrinking supply:
  - Short-term liquidity management and funding effects appear largely transitional; market participants have made significant adjustments.
  - Longer-term portfolio management consequences are harder to accommodate: a dearth of high quality, long-maturity fixed-income instruments increases "gap risk" for managers with long-duration liabilities (notably insurance companies and pension funds).
  - If private risks are not well managed, they could pose financial stability challenges in some national markets.
- Hedging interest-rate risk:
  - U.S. treasuries have become less reliable and more expensive for hedging interest rate risk due to increased market risk and reduced correlations with other assets.
  - Two contrasting market views:
    - View 1: Other instruments (highly rated corporate and agency debt, some bank liabilities) will substitute for treasuries; the Treasury must at least maintain a deep and liquid short-term bill market.
    - View 2: Private financial instruments cannot substitute for treasuries as a safe haven; disappearance of a large, deep, liquid treasury market would fundamentally alter U.S. and international finance, especially during stress.
  - Possible substitutes as safe havens in U.S. dollar markets: claims on U.S. financial institutions and securities issued or guaranteed by agencies (notably Fannie Mae, Freddie Mac, and FHLB). The supply of agency securities is presently not much less than the free-float of treasury securities, but agency securities have some private credit risk that is time-varying.
  - Synthetic nearly risk-free tranches (e.g., senior tranches of CMOs and CLOs) are conceptually possible but creating a sufficiently large supply appears unlikely; the publicly-held stock of treasury securities is currently more than half as large as the entire stock of private corporate debt outstanding in the United States.
  - If such synthetic instruments were to serve as instruments of Fed intervention, their supply would have to grow at least at the rate of base money growth, which has been close to 8 percent on average over the past several decades.

### Effects on benchmark portfolios and market dynamics
- Treasuries’ shrinking share in benchmark fixed-income portfolios has two main consequences:
  - Other fixed income segments, particularly U.S. and European corporate sectors, receive higher weights in benchmark portfolios, producing increased demand for bonds in these segments.
  - Higher weights on corporate markets in benchmark indexes may have altered market dynamics; prices of private credit depend on portfolio rebalancing by a wider and more geographically diverse set of institutions. Some market participants point to this as a factor underlying the increase in spreads in higher-yield bond markets in late 2000.
- Market liquidity and trading strategies:
  - Reduced actively traded treasury stock challenges trading strategies that take views on the slope and shape of the yield curve (for example, shorting long-term bonds and buying short-term bonds to play a steepening view).

### Is the international role of the dollar likely to be affected?
- Current role:
  - The U.S. dollar is the main currency of denomination for international financial transactions, accounting for about 40 percent of international bonds and bank loans.
  - The dollar’s predominance reflects: perceptions of U.S. economic and financial stability and infrastructure; depth and liquidity of U.S. dollar fixed-income markets; and historical use of U.S. treasury securities as the main intervention tool in foreign exchange markets by central banks.
- Market view on future role:
  - The predominant view among market participants is that the international role of the dollar will not shift despite substitution of other instruments for treasuries in some functions.
- Key uncertainties:
  - Whether other instruments can fully substitute for treasuries as a safe haven.
  - How smooth the transition to alternative safe-haven assets will be, how market dynamics will be altered, and how domestic and international systemic risks will change remain unanswered.

*Source: _wp0161*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2001/_wp0161.pdf_