Monday, November 12, 2001

On Oct. 31, Treasury Undersecretary Peter Fisher shocked the government bond market by announcing an end to the Treasury’s 30-year bond.

Although rumored for some time, the actual announcement still took markets by surprise, leading to charges that the Treasury Department is attempting to manipulate them for political purposes.

Treasury bonds rise and fall in price, just as stocks do, because once a bond is issued its interest rate is fixed for the life of the bond. Thus, when market interest rates rise or fall, the bond’s price must rise or fall to adjust. When interest rates rise, bond prices fall. When rates fall, prices rise. For example, if interest rates fell in half, then bond prices would have to roughly double so the effective interest rate would fall to market levels.

At better than $3 trillion, the Treasury bond market is huge. Although some people buy bonds and hold them until they mature, the vast majority are traded just like stocks. People buy them in anticipation of a fall in interest rates and potentially large capital gains. Such gains are magnified by the fact that many bond trades are done in futures markets, where buyers need only put up a fraction of the price.

The equivalent of a $100,000 Treasury bond can be purchased for about $2,000. If interest rates drop quickly, someone with a futures contract can make many times their investment overnight.

For example, someone buying a 30-year Treasury bond futures contract on Oct. 30 could have more than doubled their money the following day, after the Treasury announcement.

The reason is that there is significant demand for Treasury bonds by banks, insurance companies and other financial institutions. They use such bonds to hedge their liabilities.

Once they thought that there would be no more 30-year Treasuries, they increased their buying of those previously issued. The increased demand for these bonds had the effect of lowering the interest rate. The rate on the 30-year bond has now fallen from about 5.2 percent before the announcement, to a current level of about 4.8 percent.

Initially, the Treasury came under fire for its unexpected announcement. Normally, the Treasury’s borrowing is fairly predictable and markets were expecting about $4 billion in new 30-year bonds. Indeed, market interest rates had risen in anticipation of the new supply. Ironically, this interest rate rise contributed to the Treasury’s decision to suspend its long bond, as it is known.

Those expecting rising interest rates often sell “short,” which allows them to make money when prices fall. Those who had done so recently were thus caught flat-footed when interest rates fell, causing them to lose money. Some accused the Treasury of manipulating the bond market to bring down long-term interest rates. Indeed, in years past the Treasury has in fact done exactly that. Back in the 1960s, it had a policy called “Operation Twist,” which tried to raise short-term rates and lower long-term rates by changing the mix of Treasury securities being issued.

That does not appear to be the case now. Economist Brian Wesbury of Griffin, Kubic, Stephens and Thompson in Chicago thinks the Treasury was just doing what made sense under the circumstances. He notes that the normal spread between 10-year bonds and 30-year bonds is about 35 basis points (0.35 percent), but had lately risen to 75 basis points. Had the Treasury gone ahead and issued $4 billion of new 30-year bonds, therefore, it would have cost taxpayers about $500 million in additional interest over the life of the bonds.

The Treasury has not always been so sensitive to market conditions. Back in 1981, it issued 30-year bonds at double-digit interest rates, even though it was telling the world that rates would soon fall. If it believed its own forecast, then issuing long bonds at that time made no sense. It would be like refinancing your mortgage even though you believe interest rates are going to fall shortly. The effect was to saddle taxpayers with huge, unnecessary interest payments, while undermining the Treasury’s credibility at the same time.

The Treasury’s 1981 mistake was due to a policy of trying to lengthen the average debt. The Clinton administration sensibly reversed this policy and shortened the debt, leading to significant interest savings for taxpayers, because short-term rates tend to be lower than long-term rates. However, budget surpluses have caused the length of the debt to rise again, as the Treasury retires its short-term debt. In abandoning the long bond, it is only trying to give taxpayers a break, not manipulate the bond market.

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