Decisions made by the Treasury get much less attention than those made by the Federal Reserve, but they can be even more consequential for interest rates — and the entire US economy.
A case in point is the current debate over the maturity of the bonds and bills the Treasury sells at auction. An influential report published last month argued that the Treasury is issuing too much short-term debt, undermining the Fed’s efforts to slow down the economy. Then former Treasury Secretary Steve Mnuchin said earlier this month that the Treasury should discontinue the 20-year bond because of lack of demand.
These apparently contradictory pieces of advice illustrate a basic principle and the dilemma that follows: In an ideal world, the Treasury would issue more longer-term debt. In the real world, however, it is not clear bond buyers want it.
The question is why. Many savers and pension funds would be better off owning longer-term bonds, as their short-term holdings expose them to unnecessary interest-rate risk. Yet they prefer short-term debt because of both misguided financial industry practices and government regulations.
The maturity of the nation’s debt is important in part because it determines how much interest the US pays on its debt: Different maturities command different interest rates. But the Treasury should not just choose to issue debt with the lowest rate, since rates change over time in unpredictable ways. Long-term rates seem relatively high today, for example — but given the size or the nation’s debt and its demographic challenges, there are reasons to think they will go even higher. Locking in rates today could save taxpayers money or protect them from extra risk.
Over the last 40 years, the share of bills — that’s debt to be paid back in one 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 the maturity of the debt determines the shape of the yield curve. That report, from my Manhattan Institute colleague Stephen Miran and the famous economist and pessimist Nouriel Roubini, argues that the Treasury’s decision to sell more shorter-term securities is the equivalent of “one-point cut in the Fed Funds rate.” In their view, the Treasury is usurping the Fed’s power: If the Fed won’t reduce rates, the Treasury will.
The Treasury, for its part, maintains that while it takes such macro factors into consideration, it sells largely what the market demands. US Treasuries are the world’s safest and most liquid asset. The government must meet the needs of the market and not create too many surprises or it risks financial turmoil. And the market wants shorter-term debt.
This is very different from the situation in the UK, where demand for long-term gilts is high in large part because pension funds there buy them to hedge their liability risk, which they do for both regulatory and non-regulatory reasons. In the US, most pensions are in the public sector, and regulations encourage investment in much riskier assets.
Only about 20% of US public-pension portfolios are even in 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 the larger public pension’s fixed-income portfolio is five or six years, even though the duration of their liabilities (the benefits they must pay) is typically longer than 12 years. This duration mismatch creates an unnecessary risk.
This risk could be avoided if pensions bought more longer-term bonds instead. But pensions have no incentive to hedge, because their regulatory guidance suggests they measure their liabilities based on their expected rate of return. The higher that number — that is, the riskier the investment — the smaller a pension’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, odds are they would have more invested in long-term bonds.
Equally concerning are the portfolios of Americans with a defined contribution plans such as 401(k)s. Think of the money you need in retirement as a series of bond payments; you would need them to pay out over 20 years, which means a duration of about 10 to 14 years. But most retirement target-date funds set the duration of payments at about five years. So individual savers face the same duration mismatch that public pensions do — but without the government guarantee.
This is because the retirement industry has trained investors to focus on how their investment is doing each year, rather than on how to maintain a consistent income in their retirement. If the industry were targeting the latter goal, then savers would demand longer-duration assets, too. Adjusting regulations, such changing guidance for default investment options, could right this.
The future of interest rates is always unknown. America’s heavy debt burden suggests rates will rise eventually, but they may fall before then — especially if there is a recession in the next few years. And bond investing can be risky, as is issuing debt.
That’s why the Treasury should lock in low rates on more of its debt while it can. It is also why pension funds and individual savers face unnecessary risk in retirement. There is a single solution to both of these problems: Savers and pension funds should hedge their risk by buying longer-term debt, which would increase the demand for long-term Treasury bonds.
So far, however, between misguided regulation and a misunderstood risk, there is a bias for debt of shorter duration. All of which means that, in the long term, pension regulations may be far more consequential than what the Fed does next month.
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