Presentation to the Treasury Borrowing Advisory Committee · 2020. 5. 18. · Tax Receipts Continue...

U.S. Department of the TreasuryOffice of Debt ManagementNovember 2, 2010

Presentation to theTreasury Borrowing Advisory Committee

Agenda

UNITED STATES DEPARTMENT OF THE TREASURY2

•Fiscal Developments

•Auction Demand

•Portfolio Metrics

•Long-Term Challenges

FISCAL DEVELOPMENTS

3

Tax Receipts Continue to Improve


-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

Mar

-00

Jun-

00S

ep-0

0D

ec-0

0M

ar-0

1Ju

n-01

Sep

-01

Dec

-01

Mar

-02

Jun-

02S

ep-0

2D

ec-0

2M

ar-0

3Ju

n-03

Sep

-03

Dec

-03

Mar

-04

Jun-

04S

ep-0

4D

ec-0

4M

ar-0

5Ju

n-05

Sep

-05

Dec

-05

Mar

-06

Jun-

06S

ep-0

6D

ec-0

6M

ar-0

7Ju

n-07

Sep

-07

Dec

-07

Mar

-08

Jun-

08S

ep-0

8D

ec-0

8M

ar-0

9Ju

n-09

Sep

-09

Dec

-09

Mar

-10

Jun-

10S

ep-1

0

Corporate Taxes Withheld Taxes Nonwithheld Taxes

Note: Adjusted for 9/11/01 Corporate Tax Receipts disruptionSource: Monthly Treasury Statement

Quarterly Tax ReceiptsYear over Year Percentage Change

A closer look at Q4 FY2010 ending Sept. 30, 2010 :Corporate: +43%Withheld: +5%Nonwithheld: 0%

Note: Data plotted are year over year changes in quarterly receipts

Receipts as a Percentage of GDP are Projected to Reach Historic Norms

UNITED STATES DEPARTMENT OF THE TREASURY

Receipts as a Percentage of GDP are Projected to Reach Historic Norms

5

0%

5%

10%

15%

20%

25%

30%

$0

$500

$1,000

$1,500

$2,000

$2,500

$3,000

FY19

60

FY19

62

FY19

64

FY19

66

FY19

68

FY19

70

FY19

72

FY19

74

FY19

76

FY19

78

FY19

80

FY19

82

FY19

84

FY19

86

FY19

88

FY19

90

FY19

92

FY19

94

FY19

96

FY19

98

FY20

00

FY20

02

FY20

04

FY20

06

FY20

08

FY20

10

FY20

12

FY20

14

Receipts Deflated by GDP Deflator (LHS) Receipts as a % of GDP (RHS)

Total Inflation Adjusted ReceiptsIn 2005 $ Billions, Percentage of GDP

OMB FY2011MSR Budget Estimates

Receipts as Percentage of GDP50-Year Average: 18%50-Year High: 21% (FY2000)50-Year Low: 15% (FY2009)FY 2010 based on OMB projected GDP: 15%

Source: OMB projected GDP and GDP deflator, Monthly Treasury Statement receipts

TARP Repayments Continue


-$500

-$400

-$300

-$200

-$100

$0

$100

$200

$300

$400

$500

-$125

-$100

-$75

-$50

-$25

$0

$25

$50

$75

$100

$125

Oct

-08

Nov

-08

Dec

-08

Jan-

09

Feb-

09

Mar

-09

Apr

-09

May

-09

Jun-

09

Jul-0

9

Aug

-09

Sep

-09

Oct

-09

Nov

-09

Dec

-09

Jan-

10

Feb-

10

Mar

-10

Apr

-10

May

-10

Jun-

10

Jul-1

0

Aug

-10

Sep

-10

Repayments, Dividends, Interest (LHS) Cash Outflows (LHS) Cumulative Net Cash Flow (RHS)

TARP Cash FlowsIn Billions $

The Automotive Industry Financing Program providedapproximately $80bn in loans and equity investment.

In June, over $68bn was repaid to the CapitalPurchase Program by JPMorgan, Morgan Stanley,Goldman, US Bancorp, AMEX, BONY, BB&T,Capital One, State Street, and Northern Trust.

In March, the Term Asset -BackedLending Facility , a joint venture with the Federal Reserve, was launched.

On October 14, 2008, the Capital Purchase Program is launched. By January 1, 2009, over $247bn in funds had been disbursed to U.S. banks.

In December, Bank of America,Wells Fargo, and Citi repaid$90bn.

Non-Marketable Redemptions Have Increased Marketable Issuance


Non-Marketable Redemptions Have Increased Marketable Issuance

7

-$30

-$20

-$10

$0

$10

$20

$30

Q1 2005

Q2 Q3 Q4 Q1 2006

Q2 Q3 Q4 Q1 2007

Q2 Q3 Q4 Q1 2008

Q2 Q3 Q4 Q1 2009

Q2 Q3 Q4 Q1 2010

Q2 Q3 Q4

Savings Bond Foreign Series SLGS

Net Non-marketable IssuanceIn Billions $

Source: Monthly Treasury Statement

The Budget Deficit for Fiscal Year 2010 Narrowed Modestly


Source: OMB for end of Fiscal Year, Monthly Treasury Statement for other months

0

200

400

600

800

1,000

1,200

1,400

1,600

October November December January February March April May June July August September

FY2008 FY2009 FY2010

Cumulative Budget Deficits by Fiscal YearIn Billions $

FY2010 Deficit = $1.294 trillion

Net Financing Amounts Have Recently Exceeded Budget Deficits


Net Financing Amounts Have Recently Exceeded Budget Deficits

9

Budget Def icit$162

Budget Def icit$459

Budget Def icit$1,413 Budget Def icit

$1,294

-$200

$0

$200

$400

$600

$800

$1,000

$1,200

$1,400

$1,600

$1,800

$2,000

FY2007 FY2008 FY2009 FY2010Other Guaranteed Loan Accounts (SBA, HUD, Education)Other Direct Loans Education (Direct Student Loans, Loan Purchases)TARP & HERA (Direct Loans) Change in Operating Cash BalanceBudget Deficit

Net Financing: $206 Billion

Net Financing: $769 Billion

Net Financing: $1,742 Billion

Net Financing: $1,483B illion

Annual Budget Deficit and Net FinancingFiscal Year in Billions $

Total Direct Loans: $399 Billion

Total Direct Loans: $150 BillionTotal Direct Loans: TARP, HERA, Education 'sDirect Student Loans and

Loan Purchases and Other Direct Loans

Source: Monthly Treasury Statement

Primary Dealer and Government Deficit Estimates


FY 2010-2012 Deficit and Borrowing Estimates $ Billions

PrimaryDealers* CBO OMB

FY 2011 Deficit Estimate 1,214 1,066 1,416FY 2012 Deficit Estimate 1,023 665 911FY 2013 Deficit Estimate 906 525 736FY 2011 Deficit Range 1,075-1,350FY 2012 Deficit Range 800-1,350FY 2013 Deficit Range 600-1,300

FY 2011 Marketable Borrowing Range 1,026-1,400FY 2012 Marketable Borrowing Range 800-1,400Estimates as of: Oct 2010 Aug 2010 July 2010

*Based on Primary Dealer feedback on October 25, 2010. Deficit estimates are averages.

AUCTION DEMAND

11

12

Auctions Continue to Exhibit Strong Coverage


Source: Treasury Investor Class Data

1.0

1.5

2.0

2.5

3.0

3.5

$0

$500

$1,000

$1,500

$2,000

$2,500

FY2000 FY2001 FY2002 FY2003 FY2004 FY2005 FY2006 FY2007 FY2008 FY2009 FY2010

Weighted Average Coverage Ratio on Notes and Bonds In Billions $, Coverage Ratio

Gross Private Issuance (LHS) Weighted Average Coverage Ratio (RHS)

Note: Excludes TIPS and Bills issuance.

13

Bid-to-Cover Ratios for Other Sovereign Issuers


1

1.5

2

2.5

3

3.5

2005 2006 2007 2008 2009 2010

Canada France Germany UK US

Nominal Coupon Auction Bid-to-Cover Ratios for Other Sovereign IssuersWeighted Average by Allotment Amount, Calendar Year

Source: Bank of Canada, Agence France Tresor, Deutsche Finanzagentur, UK Debt Management Office

14

Investment Funds Have Increased Coupon Auction Participation


Investment Funds Have Increased Coupon Auction Participation

Source: Treasury Investor Class Data; Data through 9/30/2010Note: Includes TIPS but excludes Bills; *FY2005 through FY2009

SOMA, 3% Depository Institutions, 1%

Individuals, 1%

Primary Dealers, 43%

Other Dealers & Brokers , 8%

Investment Funds , 21%

Foreign & International , 23%

FY2010: Average Investor Class Allotments

SOMA, 11% Individuals, 1%



Investment Funds , 14%

Foreign & International , 16%

Five-Year Average of Investor Class Allotments*

15

Bill Auctions Exhibiting an Increase in the Diversity of Participants


Bill Auctions Exhibiting an Increase in the Diversity of Participants

Source: Treasury Investor Class Data; Data through 9/30/2010

SOMA, 4% Depository, 1%Individuals, 2%



Investment Funds, 14%

Foreign, 14%

Other, 2%

FY2010: Average Investor Class Allotments

*FY2005 through FY2009

SOMA, 15%Individuals, 1%


Other Dealers & Brokers ,

5%

Investment Funds, 11%

Foreign, 8%

Other, 3%

Five-Year Average of Investor Class Allotments*

16

TIPS Auctions Continue to Perform Well


1.0

1.5

2.0

2.5

3.0

3.5

4.0

7/1/

04

10/1

/04

1/1/

05

4/1/

05

7/1/

05

10/1

/05

1/1/

06

4/1/

06

7/1/

06

10/1

/06

1/1/

07

4/1/

07

7/1/

07

10/1

/07

1/1/

08

4/1/

08

7/1/

08

10/1

/08

1/1/

09

4/1/

09

7/1/

09

10/1

/09

1/1/

10

4/1/

10

7/1/

10

10/1

/10

1/1/

11

Bid-to-Cover RatiosBids Tendered Divided by Bids Accepted

5-Year 10-Year Bond

17

Concentration in TIPS Secondary Market Trading has Declined


Source: Federal Reserve Bank of New York

15

20

25

30

35

40

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Q1C

Y20

00

Q3C

Y20

00

Q1C

Y20

01

Q3C

Y20

01

Q1C

Y20

02

Q3C

Y20

02

Q1C

Y20

03

Q3C

Y20

03

Q1C

Y20

04

Q3C

Y20

04

Q1C

Y20

05

Q3C

Y20

05

Q1C

Y20

06

Q3C

Y20

06

Q1C

Y20

07

Q3C

Y20

07

Q1C

Y20

08

Q3C

Y20

08

Q1C

Y20

09

Q3C

Y20

09

Q1C

Y20

10

Q3C

Y20

10

Primary Dealer Market Share in TIPS by QuintilePercentage of Secondary Market Flows, Number of Primary Dealers

1st Quintile (L) 2nd Quintile (L) 3rd Quintile (L) 4th Quintile (L) 5th Quintile (L) Primary Dealers (R)

PORTFOLIO METRICS

18

19

Nominal Coupons and Bills as a Percentage of the Portfolio


24%

20%

25%

30%

35%

40%

2000

-01

2000

-04

2000

-07

2000

-10

2001

-01

2001

-04

2001

-07

2001

-10

2002

-01

2002

-04

2002

-07

2002

-10

2003

-01

2003

-04

2003

-07

2003

-10

2004

-01

2004

-04

2004

-07

2004

-10

2005

-01

2005

-04

2005

-07

2005

-10

2006

-01

2006

-04

2006

-07

2006

-10

2007

-01

2007

-04

2007

-07

2007

-10

2008

-01

2008

-04

2008

-07

2008

-10

2009

-01

2009

-04

2009

-07

2009

-10

2010

-01

2010

-04

2010

-07

BillsPercentage of Total Portfolio

Average 2000 - 2007

Note: Includes SFP and CMBs

21% as of 9/30/2010

69%

50%

55%

60%65%

70%

75%

80%

2000

-01

2000

-04

2000

-07

2000

-10

2001

-01

2001

-04

2001

-07

2001

-10

2002

-01

2002

-04

2002

-07

2002

-10

2003

-01

2003

-04

2003

-07

2003

-10

2004

-01

2004

-04

2004

-07

2004

-10

2005

-01

2005

-04

2005

-07

2005

-10

2006

-01

2006

-04

2006

-07

2006

-10

2007

-01

2007

-04

2007

-07

2007

-10

2008

-01

2008

-04

2008

-07

2008

-10

2009

-01

2009

-04

2009

-07

2009

-10

2010

-01

2010

-04

2010

-07

Nominal CouponsPercentage of Total Portfolio

Average 2000 - 2007

72% as of 9/30/2010

TIPS Issuance Will Continue to Increase


0%

3%

6%

9%

12%

$0

$25

$50

$75

$100

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010YTD

TIPSCalendar Year Issuance in Billions $, Percentage of Portfolio

5‐Year (L) 10‐Year (L) 20‐Year (L) 30‐Year (L) Projected (L) TIPS as % of the Portfolio (R)

Average Maturity of the Debt Continues to Lengthen


40

45

50

55

60

65

70

75

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

Average Maturity of Marketable DebtIn Months

Average Maturity Without Supplementary Financing Bills Average Length (Outstanding)

Current 58.6 as of 9/2010Average 58.1

Min 42.4 in 4/1980Max 70.9 in 5/2001

Statistics on Average Maturity since CY1980

Percentage of Debt Maturing in the Near-Term is at Historic Lows


e Near-Term is at Historic Lows

22

54%

44%

30%

20%

30%

40%

50%

60%

70%

Jan-

90Ju

l-90

Jan-

91Ju

l-91

Jan-

92Ju

l-92

Jan-

93Ju

l-93

Jan-

94Ju

l-94

Jan-

95Ju

l-95

Jan-

96Ju

l-96

Jan-

97Ju

l-97

Jan-

98Ju

l-98

Jan-

99Ju

l-99

Jan-

00Ju

l-00

Jan-

01Ju

l-01

Jan-

02Ju

l-02

Jan-

03Ju

l-03

Jan-

04Ju

l-04

Jan-

05Ju

l-05

Jan-

06Ju

l-06

Jan-

07Ju

l-07

Jan-

08Ju

l-08

Jan-

09Ju

l-09

Jan-

10Ju

l-10

Percentage of Debt Maturing in Next 12 to 36 Months

Maturing in 12 Months Maturing in 24 Months Maturing in 36 Months

Note: Data through 9/30/2010

LONG-TERM CHALLENGES

23

OMB FY2011 Mid-Session Review Projections


Source: OMB

-18%

-16%

-14%

-12%

-10%

-8%

-6%

-4%

-2%

0%

2%

4%

-$1,600

-$1,400

-$1,200

-$1,000

-$800

-$600

-$400

-$200

$0

$200

$400

1950

1952

1954

1956

1958

1960

1962

1964

1966

1968

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

2014

2016

2018

2020

Budget Surplus/DeficitIn Billions $, Percentage of GDP

Surplus/Deficit $ (LHS) Surplus/Deficit Percentage of GDP (RHS)

OMB FY2011 Mid-Session Review

OMB Long-Term Debt Metrics


Source: OMB

0%

20%

40%

60%

80%

100%

120%

$0

$5

$10

$15

$20

$25

$30

1950

1952

1954

1956

1958

1960

1962

1964

1966

1968

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

2014

2016

2018

2020

Fiscal Year Outstanding DebtIn Trillions $, Percentage of GDP

Held by Public (LHS) Held by Government Accounts (LHS) Government Accounts As a % of GDP (RHS) Public As a % of GDP (RHS) Gross As a % of GDP (RHS)

OMB FY2011Mid-Session Review

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

$0

$100

$200

$300

$400

$500

$600

$700

$800

1950

1954

1958

1962

1966

1970

1974

1978

1982

1986

1990

1994

1998

2002

2006

2010

2014

2018

Fiscal Year Interest ExpenseIn Billions $, Percentage of GDP

Interest Expense (LHS) Interest Expense as a % of GDP (RHS) Average Interest Expense%

OMB FY2011Mid-Session Review

Note: Interest costs based on net interest on Treasury debt minus interest on trust funds and other income.

Average 1960-20102%


What adjustments to debt issuance, if any, should Treasury make in consideration of its financing needs in the short, medium, and long term?

Comparing October and April levels of issuance, Treasury has cut $328 billion in annualized borrowing capacity.

2Y Note 3Y Note 5Y Note 7Y Note 10Y Note 30Y Bond Sum

April Coupon Issuance $44 $40 $42 $32 $25/$21/$21 $16/$13/$13

October Coupon Issuance $35 $32 $35 $29 $24/$21/$21 $16/$13/$13

% Change April-October -20% -20% -17% -9% -2% 0%

Annualized Cuts From October $108 $96 $84 $36 $4 $0 $328

Treasury Borrowing Advisory Committee Presentation to Treasury

Charge #2

November 2, 2010

Outlook for Non-Bank Financial Institutions Post 2008 Financial Crisis

November 2, 2010

Prior to the 2008 financial crisis, a number of non-bank financial institutions played a critical role in providing credit and liquidity across the global financial system. Many of these entities now play a more diminished role in the allocation of credit. Please discuss the current state of non-bank financial institutions and the outlook going forward. What are the implications for financial markets and the Treasury market specifically?

2

Shadow bank liabilities vs traditional bank liabilitiesShadow bank liabilities vs traditional bank liabilities

Shadow banking liabilities shrank during the crisis,but still exceed those of traditional banking

0

5

10

15

20

25

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

$tn

Traditional bank liabilities

Shadow bank liabilities

Source:Federal Reserve

2

3


Shadow banking liabilities shrank during the crisis,but still exceed those of traditional banking (cont)

Shadow bank liabilitiesShadow bank liabilities

0

5

10

15

20

25

1980 1985 1990 1995 2000 2005 2010

MM

ABS

GSE pools

GSE debt

Security RP

Repo

CP

$tn

MM: $2.9tn

ABS: $2.8tn

GSE pools:$1.0tn

GSE debt:$6.7tn

Security RP:$0.8tn

Repo: $1.5tn

CP: $1.1tn

Traditional bank liabilitiesTraditional bank liabilities

-1

1

3

5

7

9

11

13

15

1980 1985 1990 1995 2000 2005 2010

Misc Taxes payable Credit instruments Fed funds & Security RP Large time deposits Small time deposits Chk deposits Interbank

Misc: $2.4tn

Credit instr: $2.0tn

Large time deposits:

$1.7tn

Small time deposits:

$5.1tn

Chkdeposits:

$0.8tn


$tn

3

4

Taxable money fund and securities lenders assets under managementTaxable money fund and securities lenders assets under management

Key liquidity investors were transformed by the crisis

1.0

1.5

2.0

2.5

3.0

3.5

2Q07 4Q07 4Q08 4Q09 2Q10

$tn

Sec Lenders

Biggest buyers of floating rate financial debt maturing 1yr <3yr

Taxable MMF

Biggest buyers of financial debt maturing < 1yr

Note: Securities lenders assets are J.P. Morgan estimatesSource: J.P. Morgan, iMoneyNet

4

5

Prime money market fund AuMPrime money market fund AuM

Source: iMoneyNet as of October 20, 2010

Balances in money funds have declined significantly since September 2008 but are higher than pre-crisis levels

500

750

1,000

1,250

1,500

Jan-07 Jul-07 Jan-08 Aug-08 Feb-09 Aug-09 Mar-10 Sep-10

Prime Inst

Pre-crisis: Jun 30, 2007

Prime Retail

Pre-Lehman bankruptcy:

Sep 12, 2008

Government money market fund AuMGovernment money market fund AuM

0

250

500

750

1,000

1,250

Jan-07 Jul-07 Jan-08 Aug-08 Feb-09 Aug-09 Mar-10 Sep-10

Govt Inst

Pre-crisis: Jun 30, 2007

Pre-Lehman bankruptcy:

Sep 12, 2008

Govt Retail

$bn $bn

$1,071bn

$551bn

$1,323bn

$741bn

$964bn

$661bn

$617bn

$188bn

$686bn

$236bn

$283bn

$171bn

Balances in Prime funds have returned to pre-crisis levels

while Government MMF AuMhave grown

5

6

Credit sensitive money market assets fell during the crisis

5

6

7

8

9

10

Jan-07 Oct-07 Jul-08 Apr-09 Jan-10 Sep-10

Source: J.P. Morgan; Data through September 30, 2010

-26%

26%

5%2%

-28% -28% -30%

-66%To

tal e

x UST

Agenc

y DN

Neg. C

DsAge

ncy C

pnBon

ds <

13m

Repo

Unsec

ured

CP

ABCP

Percentage change in asset classes since Jun 2007Percentage change in asset classes since Jun 2007Supply of money market instruments excluding TreasuriesSupply of money market instruments excluding Treasuries

� The size of the shadow banking system has shrunk significantly already

� Sophisticated ABCP issuers such as SIVs and securities arbitrage vehicles have become extinct as liquidity investors shy away from market-valued based structures and mortgage exposures. Traditional cash-flow, client funding ABCP models are what remains today

� Repo utilization has also declined as dealers have delevered and reduced their reliance on repo as a funding source

6.5

$tn

9.6

6

7

Cumulative changes in Repo and ABCP outstandingCumulative changes in Repo and ABCP outstanding

Source: Federal Reserve, J.P. Morgan

Certain products providing leverage to banks and financials havedeclined, even as cash in banks and money funds have grown

(2,250)

(2,000)

(1,750)

(1,500)

(1,250)

(1,000)

(750)

(500)

(250)

0

250

500

750

Jun-07 Jan-08 Jul-08 Jan-09 Aug-09 Feb-10 Aug-10

ABCP

Repo

Cumulative changes in taxable MMF and deposit balancesCumulative changes in taxable MMF and deposit balances

0

250

500

750

1,000

1,250

1,500

1,750

Jun-07 Jan-08 Jul-08 Jan-09 Aug-09 Feb-10 Aug-10

Deposits

Taxable MMF

$bn $bn

Source: iMoneyNet, FDIC

7

8

90

177 188

275328

266

176108

304

332 331

377

459515

460

305

394

509 519

652

787 781

636

413

Q4 2002 Q4 2003 Q4 2004 Q4 2005 Q4 2006 Q4 2007 Q4 2008 Q4 2009

Sec Arb Total ABCP

Sec Arb outstandings compared to the total ABCP market ($bn)Sec Arb outstandings compared to the total ABCP market ($bn)

Source: Moodys; includes U.S. and European ABCP programs (multi-seller, hybrid and securities arbitrage)

Securities financed by ABCP climbed steadily until 2007 when themarket reversed course

8

9

Taxable money fund AUM vs. total money market supplyTaxable money fund AUM vs. total money market supply

Delevering cut supply while demand has grown

(3.5)

(3.0)

(2.5)

(2.0)

(1.5)

(1.0)

(0.5)

0.0

0.5

1.0

1.5

Jun-07 Nov-07 Apr-08 Sep-08 Feb-09 Jul-09 Dec-09 May-10

$tn

Supply ex UST < 1y

Taxable MMF

Source: J.P. MorganNote: Supply data includes UST bills and coupons, agency discount notes and coupons, repo sold, unsecured commercial paper, ABCP, negotiable CDs, Bonds < 13 months and money market eligible extendible notes

9

10

Money fund balances are only partly related to demand for other risky assets like bonds and stocks

(300)

(200)

(100)

0

100

200

300

400

500

600

700

800

900

1,000

1,100

Jun-07 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09 Jun-10

Institutional MMF

Cumulative monthly flow of cash since June 2007Cumulative monthly flow of cash since June 2007

$bn

Source: iMoneyNet, ICI

Mutual funds

Retail MMF

10

11

Structured products and floating rate securities were tools for maturity transformation; Use of both have declined

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

6.0

2Q07 4Q07 4Q08 4Q09 2Q10

MBS and ABS outstandingMBS and ABS outstanding

$tn

Source: SIFMA

0

50

100

150

200

250

300

2Q07 4Q07 4Q08 4Q09 2Q10

FRN with 1 to 3 year maturity outstandingFRN with 1 to 3 year maturity outstanding

Non-agency MBS

Agency MBS

ABS

$bn

Source: J.P. Morgan

Banks, brokers and other financials relied heavily on the corporate floater market pre-crisis. The core buyer

base has shrunk as a result of the crisis

11

12

Source: Federal ReserveNote: “Other” includes loans to AIG, TALF, Maiden Lane holdings, Gold, Special drawing rights certificates, and Treasury currency outstanding

Fed emergency programs to provide temporary liquidity worked well and have largely expired as the need for them subsided

Assets at the Fed; $bnAssets at the Fed; $bn

0

500

1,000

1,500

2,000

2,500

Sep-08 Nov-08 Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09 Jan-10 Mar-10 May-10 Jul-10 Sep-10

AMLF CPFF Currency Swaps TAF Other Securities Held

Other: $299bn

Securities Held:

$2052bn

AMLF & CPFF expiration: Feb 1, 2010

MMIFF expiration: Oct 30, 2009

TALF expiration for loans collateralized by non-

CMBS eligible securities: Mar 31, 2010

TALF expiration for loans collateralized

by newly issued CMBS: Jun 30, 2010

12

13

� Investor demand for cash-like investments remains high and has actually grown during the crisis in spite of near zero interest rates

� Delevering and changes in investor assets under management and risk appetite has decreased the supply of credit sensitive products in the short term markets

� The combination of more demand and lower supply of alternative products reinforce the demand for Treasury bills and other short duration Treasuries

� Regulatory changes like 2a-7 liquidity requirements and Basel III’s liquidity coverage ratio also serve to reinforce greater holdings of Treasuries by both “shadow banks” and traditional banks

Summary and Outlook

13


Charge #3

November 2, 2010

2

TBAC Charge #3

Potential Impacts of Basel 3 Regulatory Reform

• The Basel 3 banking regulatory framework, which is expected to be implemented over the next decade, includes tighter definitions of Tier 1 capital, prescribed leverage and liquidity ratios, counter cyclical capital buffers, additional capital requirements for large interconnected firms and new limits on counterparty credit risk. Please comment on the potential impact of Basel 3 on the financial markets and the Treasury debt markets.

3

Executive Summary

Basel 3 spans stricter capital, liquidity and leverage requirements• Timing for implementation is over next decade, however markets adjusting more quickly• Capital most clearly defined, liquidity and leverage in the process of being codified but

may be most onerous constraint • Financial sector trading at 20 year low reflects significance of Basel 3 in particular with

other regulatory requirements in a slow economic environmentImpact assessment of Basel 3 complex given interplay with other policy moves• Challenge of assessing the macroeconomic, financial, and Treasury debt market impact of

the Basel 3 capital and liquidity changes is complicated by other regulatory and economic factors, such as other Basel initiatives, US regulatory reforms and Fed policy.

Impact on Treasury markets multi-faceted• Treasury requirements affected generally by economic growth and credit creation

implications of Basel 3 and more specifically by rules governing ownership of securities and loans. – Economic Growth. Economy benefits through lower volatility over the long run as a

result of reduced systemic risk. However, reduced availability and/or a higher price for credit could impinge on growth. Achieving appropriate balance of objectives remains paramount.

– Treasury Holdings. Liquidity requirements likely to cause banks to increase Treasury holdings but some flexibility to hold Agency and Agency MBS may mute the demand.

4

“Steps banking industry will take as a result of the LCR and NSFR:

• “First, banks will have to increase liquid assets(primarily by holding more central bank reserves and more Treasuries), which will crowd out holdings of higher yielding loans and securities.”

• “Second, the supply of bank credit will likely decline, and what remains will be more expensive.”

• “Third, the amount banks borrow in the short term and interbank markets will decrease sharply, while the amounts they borrow from the term markets may very well run laps around current levels”. – JP Morgan

• “In the medium term, as banks increase their capital ratios by reducing lending, access to credit is likely to become more difficult and borrowing costs are liable to increase.”

• “The proposed new regulation is likely to result in significantly higher trade financing costs and tighter access to traditional trade financing instruments, such as letters of credit.”. -- Dun & Bradstreet October 2010 Special Report

• “For the “G3” (United States, Euro Area and Japan), we project that full implementation of regulatory reform on our assumed time frame would subtract an annual average of about 0.6 percentage points from the path of real GDP growth over the five year period 2011-15, and an average of about 0.3 percentage points from the growth path over the full ten year period, 2011-2020” – IIF – Impact of Basel 3, June 2010

• “Less active money markets, higher volatility of short-term interest rates; could make the transmission of monetary policy signals more difficult. Increase in steepness of money market yield curve affects monetary policy transmission mechanism” – Lorenzo Bini Smaghi, Member of the Executive Board of the ECB September 29, 2010 on Basel 3 Liquidity

• “The core message… is that net benefits remain positive for a broad range of capital ratios… the sizeable gap between benefits and costs for a broad range of assumptions still suggests that in terms of the impact on output there is considerable room to tighten capital and liquidity requirements while still achieving positive net benefits.” – BCBS An Assessment of the long term economic impact of stronger capital and liquidity requirements, August 2010

Small and Medium Enterprises: Banking Industry

Investors Policy Makers

Different Perspectives on the Impacts of Basel 3

Basel 3 Overview

6

Basel 1 Introduced minimum capital standards for banking book

Basel 1.5 Introduced VaR model based capital for trading book

Basel 2 Recalibrated capital for banking book capital by allowing internal models

Basel 2.5 Substantially revised Basel 2 for certain credit products—Securitization, Correlation Trading

Basel 3

Introduced liquidity and funding ratiosRecalibrated quality of capital and materially raised minimum capital ratiosIntroduced higher capital requirements for certain credit products

Introduced operational risk capital

Introduced leverage ratio

Basel 3 more complex than previous Basel Accords

• Unlike prior Basel Accords which focused on one or two objectives — such as introducing a new capital standard or recalibrating an existing standard — Basel 3 has undertaken multiple actions on multiple standards in what is expected to be a relatively shorter period of time than prior Basel regulations due primarily to market expectations

7

+~60%

CurrentRWA

Pre-MitigationRWA

Capital Requirements Increase with Higher Risk Weights of Certain Asset Classes

• Based on bank disclosure to date, risk-weighted assets are expected to increase approximately 60%, pre-mitigation– Some banks have also disclosed mitigation opportunities not quantified above

• Ongoing appropriate calibration critical to support credit activities, such as securitization and hedging activities– Banks need to ration credit further, likely increasing end-user rates– Ability to hedge credit risk declines, potentially reducing extension of credit

Basel 2.5

• Incremental Risk Charge

• Securitization Framework

• Correlation Trading

• Stressed VaR

Basel 3

• Counterparty Credit Risk (CVA)

8

Tier 1 Capital Tier 1 Common

Perpetual Preferred Stock

Trust Preferred

Intangibles (e.g. MSR)

Non-controlling Interest

Deferred Tax Assets

Quality of Capital: Increased Deductions in Numerator Place Further Constraints on Bank Capital

9

2%

4.5%

2.5%

7%

2.5%

0%

Current Tier 1CommonMinimum

New Minimum pre buffer

ConservationBuffer

New Minimum SIFIBuffer

Counter-cyclicalBuffer

?

Higher Capital Requirements, Some Still to be Defined

Note: 2% Tier 1 Common minimum based on 4% minimum Tier 1 capital requirement and predominance test which implies at least 50% must be in the form of Tier 1 common equity

10

Research highlights interplay between capital requirements, ROE, lending supply and potential of lending moving to shadow banking

Note: AXP excluded from grey ranges because high 28% ROE skews the scale, making changes difficult to observe.Source: Company data, Morgan Stanley Research

Capital Calibration Will be a Key Determinant of Extent Economy Will Be Impacted by Basel 3Estimated ROEs vs. Cost of Equity for US Large Cap Banks

4%

6%

8%

10%

12%

14%

16%

18%

20%

7% 8% 9% 10%B3 Tier 1 Common Minimum for each bank

2012 ROE

Median ROE Cost of Equity

11

4.5%4.5%4.5%4.5%4.5%4.0%3.5%

6.375%5.75%5.125%

7.0%

7.875%7.25%

6.625%6.0%

5.5%4.5%

8.5%

9.875%9.25%

8.625%8.0%8.0%

8.0%

10.5%

2013 2014 2015 2016 2017 2018 2019

Required Regulatory Capital Ratios

Minimum Tier 1 Common

Conservation Buffer

MinimumTier 1 Capital

Minimum Total Capital

SIFI Buffer

CountercyclicalBuffer0 - 2.5%

?

Basel Implementation Schedule Provides a Multi-year Glide Path for Meeting Capital Ratios

Banks and investors already focused on pro-forma impact, compressing timelines

12

Liquidity Ratios Defined, Calibration Ongoing

• LCR: Likely problematic as currently proposed, particularly in its treatment of deposits and unfunded commitments– Without further calibration, requires banks to carry higher percentage of liquid assets which reduces lending capacity and ROA

• NSFR: Problematic for most banks and Basel has stated they are considering changes– “Basel NSFR suggests significant deposit shrinkage including 75-100% of non-operational deposits. Our experience in the last

cycle was inflows.... We do think it will reduce credit.” (source: JP Morgan)

Liquidity Coverage Ratio (LCR) & Net Stable Funding Ratio (NSFR)

13

Liquidity Ratio’s Secondary Impact on Economy

• Liquidity Ratio Impacts (assuming no change in rule):

– Higher Cost of Lending: For each dollar lent, more liquid assets are required which lowers lender efficiency and raises borrowing costs • May impact interbank liquidity, lower hedge availability and raise funding costs

– Expected to impact money market industry by reducing back-stop facilities for CP & TOBs necessary to meet 7-day money fund liquidity requirements

– Incremental crowding out of bonds not eligible for the Liquidity Ratio

– May incent rise of unregulated non-banks

14

Leverage Ratio Represents a Higher Bar for Most US Banks Due to Stricter Criteria; Calibration Ongoing

• Disclosure to begin 2015• Minimum ratio proposal is 3% versus today’s 5% in the US.

– Viewed as constraining given the inclusion of off balance sheet assets, suggesting meaningful deleveraging required without further calibration

Basel 3 Effect

Tier 1 Capital

Average Total Assets

Stricter Definition of Tier 1 Capital

Inclusion of off balance sheet including derivatives and contingent liquidity commitments to the corporate sector

Leverage Ratio =

15

Leverage Ratio’s Impact on Markets

Lines of Credit: Likely to lead to lower availability, higher cost

• Money market funds: business model impact if credit lines pulled in this low rate environment

• Corporates: less CP would affect balance sheet efficiency and profitability

• Municipals: cost of financing would rise

Lending: Lower availability of financial derivative hedges, likely to lead to smaller loans

• Banks: may reduce lending and raise cost of loans. Competition grows from shadow banking.

16

Large Cap Banks Trading MultipleLarge Cap Bank Index (1)

1Note1. Median of current BKX constituents excluding trust banks (STT, BK and NTRS)

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

Jan-9

2Dec

-92Nov

-93Sep

-94Aug

-95Ju

l-96

Jun-9

7Apr-

98Mar-

99Feb

-00Dec

-00Nov

-01Oct-

02Sep

-03Ju

l-04

Jun-0

5May

-06Apr-

07Feb

-08Ja

n-09

Dec-09

Oct-10

Price / Tangible Book Price / Book

Large Cap Bank Trading MultiplesPrice / Book and Price / Tangible Book Value(x)

Source SNL Financial

Trading Multiples

Large Cap Bank IndexPrice /

Book Tangible Book

Current 0.9x 1.3x

5-Year Avg 1.3x 2.1x



1.3x

0.9x

Implications for the Treasury Debt Markets

18

The goal of Basel 3 is to improve the resilience of the financial system. However, the perceived long run macroeconomic benefits are difficult to quantify with any degree of precision. And, there may be costs associated with the tightening in financial conditions that accompanies the implementation of higher capital standards and increased liquidity requirements which should be considered.

“The main benefits of a stronger financial system reflect a lower probability of banking crises and their associated output losses”– BIS

“The commonly expressed view is that whatever economic implications may result from implementing these reforms, they are a ‘cost worth paying’”– IIF

Questions for Discussion

1) What are the potential macro-economic costs associated with Basel 3 and can the risk of financial crises be appropriately reduced without constraining necessary economic growth ?

2) What are the ramifications of a compressed timeline for implementation of Basel 3 requirements ?

3) How will financial markets be impacted, in particular the Treasury market ?

Costs versus Benefits

19

Source(1) Bank for International Settlements, “Assessing the macroeconomic impact of the transition to stronger capital and liquidity requirements - Interim Report”, August 2010.(2) Douglas J. Elliott, “Basel III, the Banks, and the Economy”, The Brookings Institution, July 26, 2010.(3) Anil Kashyap, Jeremy Stein, Samuel Hanson, “An Analysis of the Impact of Substantially Heightened Capital Requirements on Large Financial Institutions”, May 2010.(4) Institute of International Finance, “International Report on the Cumulative Impact on the Global Economy of Proposed Changes in the Banking Regulatory Framework”, June 2010

What are the Potential Costs? A Number of Studies with a Wide Range of Estimates

1. BIS: Modest economic impact. Lending rates rise by about 30 bp, but these costs slowly dissipate and the long run impact is negligible. GDP reduction in G-3 after 5 years is about 0.4% -- or 1/8 the size of the IIF estimate.

2. Elliot: Modest economic impact. A large increase in capital requirements is estimated to increase average loan pricing by only about 20 bp, with little effect on availability (note: did not analyze impact of higher liquidity requirements).

3. KSH: Modest economic impact. A 10 percentage point increase in capital requirements would raise loan rates by only 25 bp to 45 bp (note: did not analyze impact of higher liquidity requirements).

4. IIF: Very large economic impact. Significant rise in lending rates (+100 bp to +200 bp in US and Europe). GDP growth over the next five years is reduced by 0.5 percentage points per year in the US and 0.9 percentage points per year in Europe. Cumulative impact on the level of real GDP in the G-3 after 5 years is -3.1%, with an accompanying sizeable effect on unemployment rates.

20

Why is the IIF’s Assessment of the Economic Impact so Different?

• The IIF simulation includes all regulatory changes (higher capital requirements, countercyclical buffers, liquidity requirements, Dodd-Frank and FCRF).

• IIF does not decompose the estimated impact on lending rates and the overall economy but it seems that the new liquidity requirements are responsible for much of the expected drag on economic growth. – Specifically, the LCR requirement leads to higher holdings of cash and government

bond assets together with less lending, while the NSFR implies a need to pay up for longer maturity deposits. Both of these factors are assumed to result in slower credit growth.

• The link between credit growth and GDP appears to be much stronger in the IIF simulation than in the BIS models.

• Finally, BIS simulations include a monetary policy response – that is, easier policy is assumed to offset some or all of the tightening in credit.

21

BIS Estimates Reflect a Modest Impact to the Economy

BIS modeled the capital and liquidity impacts independently:

• Capital: A GDP reduction of 0.38%, on a global basis after four and a half years.

• Liquidity: estimated to be a median decline in GDP on the order of 0.08% (note: the BIS analysis indicated that there was greater uncertainty regarding the estimated impact of the rise in liquidity requirements than for the higher capital standards).

BIS used a variety of models which looked at the impact on:

– Lending spreads

– Credit supply

– Monetary policy

– Liquidity

22

IIF Projects a Substantial Negative Economic ImpactChange in Real Lending Rate to Private Sector Borrowers (1)

basis points

Notes: (1) Difference between bank lending rate paths in “regulatory reform” scenario versus “base” scenario.(2) Difference between Real GDP paths in “regulatory reform” scenario versus “base” scenario.Source: IFF Estimates

2010 2012 2014 2016 2018 2020

Japan

Euro Area

US

240

200

160

120

80

40

0

Change in Real GDP (2)

%

2010 2012 2014 2016 2018 2020

Japan

US

Euro Area

0

(1)

(2)

(3)

(4)

(5)

23

Ramifications of changing adoption timeline

Analysis of Basel 3 impacts (e.g. BIS, IIF, other economists) largely assumes the 2019 timeline. Given the markets’ accelerated adoption of Basel 3, how might these analyses be adjusted, if at all?

Policy makers believe the markets will respect the timelines set out for Basel 3 adoption…

“We are not enforcing the 2019 standards today and do not expect banks to meet those standards today.We expect the banks to have come up with capital plans that show how they will meet those standards over time and I would think the markets will be very accepting of that strategy.”– William Dudley, President and Chief Executive Officer of the Federal Reserve Bank of New York : (Remarks at the 2010 Institute of International Finance Annual Membership Meeting, Washington, D.C.)

However, other organizations are pushing for quicker adoption and “As the global financial system stabilizes and the world economic recovery is firmly entrenched, phasing out intangibles completely and scaling back the transition period should be considered.”– IMF Staff Position Note October 2010 Shaping the New Financial System

Investors want banks to get there quickly….Based on 3Q10 earnings calls, investors are increasingly asking when they can expect buybacks and dividends.

24

Notes: (1) The IIF model simulation implies a sharp rise in the securities share of bank credit over the next decade. The BIS model simulation assumes a 25% increase in bank holdings of liquid assets and a lengthening of the maturity of banks' wholesale liabilities.Source: Federal Reserve H8 report for historical data, IIF for 2010-2020 estimatesShaded areas indicate recessionBank Credit equals bank loans plus securities holdings (note: it excludes asset items such as excess bank reserves).

• At present, bank credit consists of about 26% securities (mostly MBS) and 74% loans. Historically, the securities share tends to rise during and shortly after recessions, then lending usually picks up as economic recovery becomes more firmly entrenched.

Basel 3 Liquidity Requirements Imply More Securities, Fewer Loans US Bank Securities Holdings as a Share of Total Bank Credit

0.20

0.22

0.24

0.26

0.28

0.30

0.32

1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020

IIF / BIS Regulatory Change Scenario (1)

25Source: based on Federal Reserve Flow of Funds Accounts. Haver Analytics

Private Domestic Nonfinancial Debt (% change YoY)

Share of Private Nonfinancial Debt Outstanding

New Capital & Liquidity Standards will Place Ever Greater Reliance on Troubled Securities Markets

• The liquidity coverage ratio (LCR) component of Basel 3 could lead to withdrawal of backstops for ABCP and ultimately eliminate that market as a viable form of short term financing.

• Thus, any pullback in bank lending is likely to lead to a tightening in financial conditions. In particular, sectors such as small business might face significantly tighter credit availability.

Securities Markets

DepositoryInstitutions

25

30

35

40

45

50

55

60

65

1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010

(2)26

1014

26

Basel 3 Liquidity Coverage Ratio: Impact Likely to Vary Significantly Across Regions

Source National data and IIF estimates

The IIF estimates that Euro Banks fall well short of LCR standardsStatistics for various banking areas; %

Economy’s dependence on banks Distance for banks to adjust

Banks assets as % GDP

Banks’ share of credit Intermediation

LiquidityCoverage Ratio

Net Stable Funding Ratio

United States 83.1 26.6 81.8 84.3

Euro Area 346.6 73.8 27.8 61.9

Japan 168.8 52.6 92.4 82.6

27

2010 2015

Bank Holdings of Treasuries 181 Bn 675 Bn

Total Treasuries Outstanding 8.4 Tr 12.5 Tr

Bank Ownership Share (%) 2.2% 5.4%

Based on our analysis, we believe Basel 3 is likely to lead to increased bank demand for Treasuries1. The estimate for bank holdings of Treasuries in 2015 is based on analysis by Barclay's Capital which

concluded that Basel 3 liquidity requirements would lead to $400 billion of new Treasury purchases by US commercial banks. We also factor in the expected rise in overall securities holdings

2. Within the securities portfolio, banks are likely to boost their holdings of Treasuries relative to other securities because of more favorable treatment in the calculation of the LCR. Specifically, most agency securities receive a 15% haircut in the calculation of the LCR and so-called Level 2 liquid assets are limited to 40% of total liquid assets.

The Change in Liquidity Requirements is Likely to Lead to a Shift in Bank Balance Sheets

Note: The expected size of the Treasury market in 2015 is based on the latest official estimates from the CBO.

28Source Haver Analytics

• Bank holdings of Treasuries in 2015 are based on Barclay’s Capital estimates of the impact on Treasury demand as well as the expected rise in overall securities holdings.

• Holdings of agencies are based on the expected rise in overall securities holdings alone. Also, the 2015 estimates do not account for the potential impact of the 40% limitation on Level 2 liquid assets and thus are subject to considerable uncertainty.

• We calculate the expected ownership share under certain assumptions for growth in the overall markets. For Treasuries, we use the latest official CBO estimates and for agencies we assume a 4% annual growth rate.

Assessing the Impact of Basel 3 on Bank Holdings of Treasuries and AgenciesAssets Will Consist of More Securities and Fewer Loans

0.000

0.050

0.100

0.150

0.200

0.250

1980 1985 1990 1995 2000 2005 2010 2015

Bank Ownership Share of Agencies and Agency MBS Markets

Bank Ownership Share of US Treasury Market

29

Under Basel 3, excess bank reserves are among the items included in the calculation of the liquidity ratio. The US banking sector currently has an approximate $1 trillion of extra liquid assets reflecting the unprecedented expansion of the Federal Reserve’s balance sheet in recent years. Presumably, this is a temporary phenomenon and the volume of excess reserves will eventually revert to historic norms. Such a development could magnify the strains associated with the banking system’s adjustment to higher liquidity requirements. This issue also reinforces the notion that the markets are currently being buffeted by a whole host of unusual factors making it difficult to gauge the impact of major policy initiatives, such as Basel 3, on the economy and the markets.

A Final Complicating Factor to Consider …

Source: Federal Reserve Board / Haver Analytics

07 08 09 10

1,200,000

1,000,000

800,000

600,000

400,000

200,000

0

1,200,000

1,000,000

800,000

600,000

400,000

200,000

0

Adjusted Excess Reserves of Depository InstitutionsNSA, $MM

Source: Federal Reserve Board / Haver Analytics

07 08 09 10

Cash Assets: All Commercial BanksSA, $Bn

1,400

1,200

1,000

800

600

400

200

1,400

1,200

1,000

800

600

400

200


Charge #4

November 2, 2010

U.S. Treasury Borrowing Advisory Committee

Presentation to TreasuryCharge #4

Implications of Additional Policy ActionsMonetary authorities in a number of countries are considering additional

measures in an effort to improve growth. What range of measures is currently expected? What are the potential near-term and long-term impacts for financial

markets and the Treasury market specifically?

November 2, 2010

2

November TBAC Meeting

I. Market expectations for QE2

II. Medium term (1-2 year) market impacts from QE2

III. Long term (3+ years) market impacts from QE2

IV. Impact on Treasury debt issuance

V. Global impact from U.S QE policies

3

I - Market expectations for QE2

• $100bln a month (including ~$30bln of mortgage reinvestment?)

• Open-ended, no “shock and awe”

• Tied to “economic conditions” or “progress towards mandates”

• Expectations for the Fed program is for 1 year (~$1.2trln)

• If conditions do not improve, it is expected the program could expand beyond one year (and possibly include other assets over time)

4

II – Medium term impacts

• Treasury yield curve: Lower and flatter led by the 5yr to 10yr maturities

• 30Yr Yields: Remain high versus historical curve valuations

• TIPS Breakeven Inflation Rate: Bias higher

• Intermediate Swap Spreads: Wider

• Rate Volatility: Lower

• Credit Spreads: Tighter

• Term Risk Premiums: Lower

• Mortgages: Initially wider versus Treasuries, keep pace/tighter versus swaps. Tighten versus Treasury and swap curve over time.

• Equities: Higher

• Dollar: Weaker

5

Policy reshapes the yield curve

• Rates first fall and curve flattens

• Since September FOMC, 30yr point resteepens to near July levels but intermediate sector remains lower in yield

UST Par Curves

0.00

0.50

1.00

1.50

2.00

2.50

3.00

3.50

4.00

4.50

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30Years to Maturity

Yie

ld

10Yr Point 7/14/2010 Sept 21 FOMC 10/22/2010 Source: Presenter’s Firm

6

Impact of Fed purchases on the curve

Source: Presenter’s Firm

• Implied Fed purchases are based up $1.2trln in new purchases ($100bln a month) and $360bln of MBS reinvestments ($30bln a month)

• Maturity distribution based upon 2010 purchase pattern. QE2 program will likely target a longer duration profile

* Available Gross Issuance for the Fed to purchase under 35% SOMA limit

Projected 35% of Still Need Float of off-the runs

($bln) Implied Fed Purchases Gross Issuance Gross Issuance to Buy available to Fed (up to 35%) Difference

1.5-2.5yr 79.6 364.0 127.4 - 220.2 220.19

2.5-4yr 238.7 328.0 114.8 123.9 212.8 88.95

4-6yr 464.9 364.0 127.4 337.5 221.4 (116.08)

6-10yr 619.3 573.0 200.6 418.8 290.1 (128.70)

10+yr 124.8 160.0 56.0 68.8 121.2 52.38

TIPS 31.2 119.0 41.7 - 145.5 145.49

7

Rising inflation expectations impact 30yr yields

Per

cent

Per

cent

10s30s

• The fear of reflation or weaker USD has pushed 30yr yields 22bps higher vs. 10yr yields since the September 21st FOMC meeting

• 10yr Inflation Breakevens have also risen 36bps since September 21st.

8

Expectations of QE widen swap spreads

Source: Bloomberg

• The lack of net Treasury supply after Fed purchases will drive swap spreads wider in the intermediate sector

• Implications for tighter repo markets also push swap spreads wider

9

Implied volatility will naturally fall as 0% bound approaches

Source: Presenter’s Firm, Bloomberg

80

90

100

110

120

130

140

150

160

170

Jan09 Apr09 Jul09 Oct09 Jan10 Apr10 Jul10 Oct10

1y5y implied 1y30y implied 10/27/2010 (at 88.34995)

R 2̂ = 69.53% (y~0.96x + 10.87)

Impl

ied

Rat

e V

ol (b

pvol

)• However, realized volatility in the long end remains higher as uncertainty and reflation

concerns build

10

Credit spreads compress despite record gross investment grade + high yield September issuance• QE is good for risk assets


11

III – Long term impacts

• Potential liquidity issues

• Does lack of supply in 5yr to 10yr sector push buyers into T-bills or 30yrs?

• Do large Fed purchases crowd out private investors? Is this the Fed’s intent to push investors out the risk curve?

• Do foreign and central bank investors diminish purchases due to the weaker dollar?

• Repo markets will tend to tighten as collateral supply shrinks due to limitations to the Fed’s System Open Market Account (SOMA) lending capabilities

• How does Fed exit QE? Sequencing previously discussed: drain reserves through reverse repos and term deposits, hike IOER/fed funds rate, then sell assets. However, due to an increasingly large balance sheet, assets may now need to be sold earlier than previously envisioned.Market reactions could be extreme when Fed signals policy tightening

12

Path of the FF rate extracted from yield curve and a more realistic tightening scenario. Note the existing curve is implying a very slow moving Fed that levels off at 3%.

Source: RBSSource: Presenter’s Firm

13

Exit strategy: When the Fed signals tightening, the probability of a quick and strong reaction is high. Below are the differences for various maturities between the Oct 22 yield curve and the yield curve consistent with the previous slide’s tightening scenario.

Changes in swap rates under scenario

-20-10

01020304050607080

2 3 4 5 6 7 8 9 10 12 15 20 30

swap maturity, years

bp c

hang

e in

sw

ap ra

te


14

Exit strategy and asset sales

• While shedding assets could potentially exacerbate the rise in market yields as exit strategy unfolds, the Interest On Excess Reserve (IOER) rate enables the Fed to manage the timing/pace of sales. Through reverse repo and the IOER, the Fed can drain reserves while running a large asset balance sheet.

• If asset sales are predictable and gradual, the impact on longer-term market rates can be minimized.

• Policy normalization would presumably occur after the economy is growing at a healthy pace. At that time, the budget situation should be improved, so that Treasury could be cutting issuance as the Fed is selling.

• The total amount of assets the Fed must ultimately sell will depend on how long QE II remains in place and how quickly policy is reversed (less runoff).

• On the positive side, asset sales can prevent another “conundrum.” In other words, the Fed now has a tool to control long term rates during a tightening cycle. This is in contrast to 2004 when 10yr yields dropped 100bps in the first year following the commencement of the tightening cycle.

15

Lack of net supply of high quality $ assets

• The net projected supply of alternative high-grade fixed income assets is also historically low

• YTD mutual fund flows show $38bln out of stocks, $185bln into bonds (all bonds)

• The projected total purchase amount of QE2 of $1.56trn exceeds the entire combined net issuance of these asset classes

(bln) 2009 2010 2011

Treasury 1284 1600 1115

Agency -17 -148 37

Agency MBS 445 -65 100

IG Corporate 150 0 100

Total 1862 1387 1352Source: Presenter’s Firm

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IV. Impact on Treasury debt issuance - should the U.S. Treasury alter its issuance strategy due to QE purchases?• The U.S. Treasury and the Federal Reserve are two distinct,

independent entities.

• It is not in the long-term interest of the U.S. Treasury and its creditors for the Treasury to appear to coordinate with one specific buyer.

• The Federal Reserve may or may not be a long-term holder of this Treasury portfolio. Therefore, to alter issuance based upon Fed buying patterns rather than desired debt maturity profiles may prove problematic in the future.

• Due to the benchmark liquidity status of Treasuries globally, the Treasury must keep issuance "regular and predictable."

• The Treasury must issue in all market conditions. If repo market or general liquidity deteriorates due to Fed purchases, Treasury could consider steps such as more frequent reopenings instead of monthly new issues in the 3yr, 5yr, and 7yr maturities.

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V. Global impact from U.S. QE policies Expectations of QE have weakened the USD…

Real Trade-Weighted USD (March 1973 = 100)

Source: Bloomberg

Other Important Trading Partners

Major Countries: (EZ + Swi + Swe + Jpn +

Can + Aus + UK)

• The USD has weakened considerably vs. the majors but not vs. others mainly due to the Asian currency pegs

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… while the US Trade imbalance has shifted decidedly toward EM countries …

US Trade Balance ($ Millions)

Source: Bloomberg

Major Countries: (EZ + Swi + Swe + Jpn + Can + Aus + UK)

All Other Countries

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… leaving surplus nations with a few choices:

1. Appreciate, allowing related adjustmentsSingapore

2. Not AppreciateUnsterilized (accommodate via intervention), importing unwelcome Fed reflationary policy (Asian nations)Sterilized (Switzerland, Brazil)

3. Institute Capital ControlsBrazil (taxes on certain foreign investments), Thailand (15% withholding tax), under consideration in Korea (withholding tax, others)

4. Enact Additional Monetary EasingJapan, potentially the UK

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Cumulative reserve growth of top 5 Treasury holders vs. DXY

Inde

x

thou

sand

billi

ons

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Asian FX reserve growth in particular has accelerated

Asia Foreign Exchange Reserves ($ billions)

Source: Bloomberg

China + Hong Kong + Taiwan + Malaysia + South Korea + Singapore + Indonesia +

Philippines

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Dollars recycled

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Importing Fed policy, China tightens

• When China intervenes in the FX market to reduce upward pressure on the renminbi, the PBOC buys US dollars from the banking system and sells renminbi, which become domestic bank reserves.

• To remove these reserves from the banking system (sterilize) , the PBOC sells bills to the banks.

• To the extent that sterilization is incomplete and reserves remain in the banking system, these reserves are a potential source of money supply growth which, if excessive, can lead to inflation (cause for benchmark rate hike in October?)

• This chart shows the relationship between FX reserve and M1 growth. The association between FX reserves and M1 suggests that at least a portion of China's FX reserves are unsterilized. Whether this is by design or not is less clear.

-100

0

100

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600

Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-100

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FX Reserves versus M1 Yuan billion and %y/y

Change in FX reserves less currency affectsM1 %y/y (rhs)

Presentation to the Treasury Borrowing Advisory Committee · 2020. 5. 18. · Tax Receipts Continue...

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