(Bloomberg Opinion) – Decisions made by the Treasury get far less attention than those of the Federal Reserve, but they may be even more important for interest rates – and for the entire US economy.
One such case is the current debate over the maturity of bonds and bonds that the Treasury sells at auction. A influential report published last month argued that the Treasury is issuing too much short-term debt, undermining the Fed's efforts to slow the economy. Then former Treasury Secretary Steve Mnuchin said earlier this month that the Treasury should terminate the 20-year bond due to lack of demand.
This seemingly contradictory advice illustrates a basic principle and dilemma: In an ideal world, the Treasury would issue more long-term debt. In the real world, however, it's not clear that bond buyers want it.
The question is why. Many savers and pension funds would be better off holding long-term bonds, as their short-term holdings expose them to unnecessary interest rate risk. However, they prefer short-term debt because of the wrong practices of the financial industry and government regulations.
The maturity of the country's debt is important in part because it determines how much interest the US pays on its debt: different maturities have different interest rates. But the Treasury should not just choose to issue debt at the lowest rate, as rates change over time in unpredictable ways. Long-term rates look relatively high today, for example — but given the country's size or debt and its demographic challenges, there's reason to think they'll go even higher. Locking in rates today can save taxpayers money or protect them from additional risk.
Over the past 40 years, the share of accounts receivable—that is, debt due in a year or less—averaged about 20% of outstanding debt. In the near-zero rate environment of the last 15 years, it fell even further, only to rise again in the last five years.
This change comes at a bad time, because debt maturity determines the shape of the yield curve. That report, by my Manhattan Institute colleague Stephen Miran and renowned economist and pessimist Nouriel Roubini, argues that the Treasury's decision to sell more short-term securities is tantamount to “cutting the Fed funds rate by one point.” According to them, the Treasury is usurping the Fed's power: If the Fed won't cut rates, the Treasury will.
The Treasury in turn, keeps that while taking such macro factors into consideration, it sells heavily what the market demands. US Treasuries are the safest and most liquid asset in the world. The government must meet the needs of the market and not create too many surprises or risk financial turmoil. And the market demands short-term debt.
This is very different to the situation in the UK, where demand for long-term needles is high in large part because pension funds there buy them to hedge their liability risk, which they do as per regulatory as well as for those. non regulatory the reasons. In the US, most pensions are in the public sector and regulations encourage investment in much riskier assets.
Only approx 20% of the US public pension portfolio they are also on fixed income. There is not much effort to hedge interest risk. What little they have in bonds tends to be in shorter-duration securities—the typical duration of larger public fixed income pensions the portfolio is five or six years, although the duration of their obligations (the benefits they have to pay) is usually longer than 12 years. This duration discrepancy creates an unnecessary risk.
This risk could be avoided if pensions bought more long-term bonds. But pensions have no incentive to hedge because their regulatory guidelines suggest they measure their liabilities based on their expected rate of return. The higher this number—that is, the riskier the investment—the smaller an annuity's liabilities appear (even if their true value is based on the yield curve). If public pensions in America were held to the same standards as private sector pensions or pensions elsewhere, it is likely that they would have invested more in long-term bonds.
Equally troubling are Americans' portfolios of defined contribution plans like 401(k)s. Think of the money you need in retirement as a series of bond payments; it would take you over 20 years to pay back, which means a duration of about 10 to 14 years. But most target retirement date funds set the duration of payments at around five years. So individual savers face the same duration discrepancy that public pensions do – but without the government guarantee.
This is because the pension industry has trained investors to focus on how their investment is doing each year, rather than how to maintain a steady income in retirement. If the industry were aiming for the latter goal, then savers would also look for longer duration assets. Regulation regulation, such a change guideline for default investment options, can fix this.
The future of interest rates is always unknown. America's heavy debt burden suggests that rates will eventually rise, but they could fall before then — especially if there's a recession in the coming years. And bond investing can be risky, as is debt issuance.
That's why the Treasury should set low rates on more of its debt while it can. This is also why pension funds and individual savers face unnecessary risk during retirement. There is only one solution to both of these problems: Savers and pension funds should hedge their risk by buying long-term debt, which would increase demand for long-term Treasury bonds.
Until now, however, between misregulation and a misunderstood risk, there is a bias towards shorter duration debt. All of this means that, in the long run, pension regulations may be far more important than what the Fed does next month.
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To contact the author of this story:
Allison Schrager at (email protected)