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FEDERAL RESERVE HANK DF SAN FRANCISCO Monthly Review Ft b 2 01969 u rn mm Umtit P f f iif lp ij j i In this issue Managing the Debt of the ’60s M echanics of Managem ent Annals of the Decade January 1969 Mechanics of Management . . . A decade of deficits has forced the Treasury's debt managers to face a number of problems in meeting their borrowing needs. A n n a ls o f the D e c a d e . . . Financing difficulties have arisen in each period as the nation has moved from recession to full employment to wartime boom. Editor: William Burke January 1969 MONTHLY REVIEW Managing the Debt of the ’60s I. Mechanics of Management hile the enactment last June of the incom e-tax surcharge may have caused some households to make undesired changes in spending and saving plans, there is at least one group of Americans for whom, as a result, life promises to become easier: the Treasury debt managers. With a Federal budget surplus now officially in prospect for the current fiscal year (as compared with the postwar record deficit of fiscal 1968), the task of financing government expenditures will be eased quite considerably. However, the Treasury is not free from deficits as such. Under the tax system pre vailing in this country, a seasonal fiscal cycle must be handled each year. Because spend ing is fairly evenly spread over the year while tax collections are not, there is regularly a deficit in the first half of the fiscal year ( JulyDecember) and a surplus in the second (Jan uary-June). The regularity and short-run nature of this problem make it a relatively simple one for the Treasury to handle, but the financing arrangements must nonetheless be made. W Borrowing money The Treasury can obtain the funds for re deeming maturing securities and for meeting shortfalls in revenues in several different ways: by using up previously accumulated cash balances; by seigniorage; or by borrow ing. Seigniorage— Treasury absorption of the difference between the circulating value of coins and their minting and bullion costs— is a very limited device, given our system of currency and coinage, and does not play an important role. Ordinarily, cash balances rep resent a much larger financial resource for any given moment, but these are of limited size and can only be depended upon for short-run adjustment. The bulk of Treasury deficit financing must be accomplished through borrowing. The Federal government borrows funds through a variety of channels—through the Treasury itself and through a number of semi-autonomous agencies. Treasury borrow ing represents the largest part, so attention is focused here on that type of borrowing rather than on flotations by Federal agencies. The Treasury sells a number of debt in struments— some marketable and some not. Savings bonds are a prime example of instru ments which the Government stands ready to redeem rather than permit to be nego tiated in a market. At the end of June 1968, outstandings of such nonmarketable issues totaled $51.9 billion. Savings bonds have not played an important role in Treasury financ ing during recent years, however, as savers have been increasingly attracted to invest ments carrying higher yields (and more risk, in many cases). Special issues to government agencies and trust funds are also nonmarketable and are a major source of funds. Technically, in creases in special issues represent surpluses of trust funds administered by the Treasury rather than net cash borrowings of the Trea sury. Nevertheless, the $59.5 billion of these issues outstanding last June does represent a lowered Treasury demand fo r b o rro w e d funds from the general public. 3 FEDERAL RESERVE BANK Marketing debt The source of most of the government’s borrowed funds continues to be the sale of marketable bills, certificates of indebtedness, notes and bonds. Outstanding marketable is sues totaled $226.6 billion at the end of June 1968, of which $91.1 billion were in Trea sury bonds (typically maturing in over 5 years), $64.4 billion were in bills (typically maturing in one year or less), and $71.1 bil lion were in notes (typically maturing in 1 to 5 years). Most issues are sold directly to the public, but some are sold also to govern ment agencies and trust funds. Once the decision has been made to sell a marketable security, the debt managers must consider several complex questions: 1) whether to offer a discount issue (bills) or one with a fixed coupon yield; 2) what maturity to offer and, if a coupon issue, what yield; and 3) under what terms the offering should be made. Prevailing (and future) economic conditions, along with the limita tions placed upon the range of possible ac tions by legal statutes, are the major deter minants in the Treasury’s deliberations. Government officials sound out various advisory groups in the financial community in order to ascertain what sort of issue would be best received by various types of buyers, this knowledge being necessary because the 4 OF SAN F R A N C ISC O Treasury must compete with other borrowers in the money market for the funds of poten tial lenders. To be sure, the Treasury is in many ways a unique institution in the market —its obligations being immune to risk of de fault, for example—but the fact remains that other securities increasingly have proved effective competitors for the investor’s dollar. The yield and maturity of the issue are, of course, of primary importance. But these are not determined independently of other features of an offering— the entire package of price and non-price terms must be designed to conform with the objectives of the financ ing operation. The attractiveness of an issue in the primary market is greatly affected by such factors as the following: the deposit re quired with subscriptions (or with bids, if the issue is sold at auction); the limit, if any, put upon subscriptions from commercial banks; the allotment procedure; the terms of payment; the call features; and the tax char acteristics. A brief examination of each of these will reveal the complexity of the debt manager’s problem. Deposit requirements In all Treasury cash offerings, those ten dering subscriptions or bids are required to put up deposits. Commercial banks are nearly always exempted from such requirements, but other lenders must deposit amounts that vary with the type of security offered. For Treasury bills, trust companies and “responsible and recognized” securities deal ers receive an exemption (along with banks), but all other bids must be accompanied by payment of two percent of the face amount of bills applied for or by an express guarantee of payment by an incorporated bank or trust company. For coupon securities the exemp tions go to banks and, on many occasions, to certain preferred lenders such as states and pension funds; deposit requirements for other subscribers have varied during the last two decades from two percent on many note is- January 1969 MONTHLY sues to as high as 25 percent on some bond issues. (For one bond issue, the 3 W s of 1985 sold in 1958, there were no exemp tions and everyone was required to deposit 20 percent.) The significance of the deposit require ments — especially for longer-term issues, which show wider price fluctuations in the secondary market — has to do with their effect on potential speculation. The percent ages are varied from operation to operation in part to meet the varying likelihood of spec ulation. It would be difficult to gauge the effectivenss of this procedure, though some critics argue that deposit ratios normally are not high enough to prevent the invasion of speculative buyers. Deposit requirements are not, however, the total arsenal in the battle against disruptive speculation— correct pric ing of an issue can play a major role in dis couraging “free riders” and other like-minded traders. When a coupon is considered more than ample and the expectation becomes wide spread that the security will therefore quick ly rise to a premium, the low deposit require ment is an invitation to speculators to sub scribe to an issue. This may well have been the case with the 314’s of 1978-83 sold in 1953; the result then was great congestion in the secondary market as the issue moved out of weak hands. The Treasury’s efforts to prevent specula tive activity are related to its attempt to place its debt in the hands of “permanent” inves tors. Thus, the deposit requirements are in tended to increase the stability of the markets for Government securities, encouraging mar ket confidence and resiliency and enhancing the Treasury’s credit against the possibility of some future stress. Commercial-bank limitations Another manifestation of the desire to locate securities as early as possible in “per REVIEW manent” hands is the limitation on commer cial-bank subscriptions that usually acompanies coupon offerings. Commercial banks hold government securities as a secondary reserve; when demand for bank loans outruns available funds, the bank may sell off some of its portfolio of securities to replenish its reserves and permit the continued extension of loans. Thus, banks frequently tend to sell securities at those times when the increased demand for funds in the market for securities is driving bond prices down and interest rates up. Consequently, bank management of secur ities portfolios often tends to increase cyclical variations in prices of governments. These activities, like speculative activities, may de ter investors who are looking for a reliably liquid asset. The fewer the Treasury securities that originally move into commercial-bank holdings, the less the potential for this par ticular type of disruptive pressure in the mar kets. (Of course, if commercial banks are to operate with secondary reserves, any limita tions by the Treasury on commercial-bank subscriptions merely shift this potential mar ket pressure to other types of securities.) As noted below, monetary-policy consid erations also influence the Treasury to avoid financing through the commercial banks. These considerations, however, are frequent ly overridden by the advantages that accrue to the Treasury from the underwriting sup port of commercial banks, and special fea tures are often added to an issue to attract commercial-bank interest. Allotments The allotment procedure followed in cash offerings also evidences the Treasury’s desire to place debt with “permanent” investors. Because subscriptions can exceed the size of the issue in cash operations, a method of allotting the available securities is necessary —whereas, in exchange offerings, all sub FEDERAL RESERVE BANK scriptions of “rights” (that is, maturing se curities) are accepted in full. Through the years a fairly standard pattern of terms has evolved, with the Treasury ren dering full allotments on all subscriptions under a certain amount (the amount varying with the maturity and size of the offering) and on subscriptions for coupon issues from certain preferred customers (such as states, public pension funds, government investment accounts and the Federal Reserve). The re mainder of the issues are allotted on a frac tional basis, with the allotment ratios some times differing for various classes of investors. “Savings-type” investors, such as pension funds, insurance companies, and mutual sav ings banks, are frequently assigned higher allotment ratios than commercial banks. Though the allotment system may, indeed, work to distribute the new securities to firm holders, it still arouses occasional criticism, with some critics claiming that the system can actually encourage speculative activity. Ac cording to this argument, the uncertainty of allotments causes large investors to “pad” their subscriptions, guessing at what the ratio will be; when these expectations are unful filled, they often must enter the market to alter their holdings. $@€8s@si€a! fiseal pattern reflects large variation in tax collections and stable flow of expenditures Billions of Dollars OF SAN F R A N C ISC O For instance, when ratios are lower than expected, investors may enter the secondary market to round out allotments; this can raise prices directly and also may encourage specu lation. When ratios are higher than expected, the excess placed on the secondary market can lower prices unduly. In addition, of course, there may be some inconvenience to buyers who have to go into the secondary market. Despite this argument, the market is sel dom far off the mark in its projections of allotment ratios, as any perusal of the leading financial newsletters would testify. More over, for some issues, it is possible to enter non-competitive bids which will be filled at the average price determined by the auction. Terms of payment Carrying further its distribution objectives, the Treasury varies from time to time the terms it specifies with regard to payment for securities— witness the provisions it has made for extended payment in several of its bond offerings over the last two decades. In each of these cases, installment plans were offered to individuals and/or savings-type buyers or to subscribers in general. The announced purpose of these provisions was to enable the Treasury to tap the savings of such in vestors as their funds accumulated over a period of several months. One interesting payment feature is the per mission— or lack thereof—for banks to credit their Treasury tax-and-loan (T & L) ac counts. Depositaries of such Treasury funds may be granted the right to pay for a portion or all of their allotment through this proce dure. This is clearly an advantage to the com mercial banks because it enables them to pay in credit instead of in Federal funds— at least until the Treasury calls its funds into the Federal Reserve. (Federal funds are the uncommitted reserves of commercial banks with the Federal Reserve.) January 1969 MONTHLY The tax-and-loan privilege can increase the attractiveness of an issue because a bank can increase its reserves by first subscribing to the issue and then selling part of its allotment. The reserves it thus receives may be put to income-earning uses until the T & L call re quires their transfer to the Federal Reserve. A bank in this way can often take a capital loss on its purchase and subsequent sale and still make a profit on the total operation. Thus, even in tight-money periods, when the reserve position of the banking system is tight, it is possible for the Treasury to attract willing buyers through this device. The tax-and-loan privilege may therefore be regarded as a means of finding initial buy ers for Treasury securities at lower interest costs. Some evidence of such cost savings is provided by the stronger tendency on T & Lprivilege issues than on other issues for lower prices to prevail in the secondary market than in the primary release. Further evidence is provided by the tendency for banks to outbid other competitors in tax-anticipation bill auc tions, where the T&L privilege is available. REVI EW When the Treasury does not wish to rely on the informal underwriting provided by government securities dealers, it may occa sionally choose to encourage commercial banks to act as the temporary underwriters of its cash offerings. The granting of tax-andloan account privilege— usually for up to full payment—was the rule rather than the exception in the 1950’s. During the current decade, however, the Treasury has been more selective. Because the creation of deposits by banks paying by credit may sometimes run counter to the general objectives of stabiliza tion policy, the Treasury in each case must weigh the importance of the banks’ under writing support. Call options Call options are yet another feature which may increase or decrease the attractiveness of Treasury issues. Call options are of two types — those which permit the Treasury to call in the security for payment at some time before the final maturity date, and those which give such an option to the security holders. The latter type has been offered on only one security sold for cash during the last two decades— the 4-percent notes of 196062. This must be considered an attractive feature for the buyer who is uncertain of being able to hold the security until final maturity, because it cuts down his risk of capital loss from a cyclical decline in secur ities prices. But how valuable the option might be is difficult to gauge, because of the difficulty of knowing the level of interest rates at the call date. The Treasury call option works in an oppo site manner; it has been historically common on some very long bond issues, but again with quite variable consequences. Ordinarily, an issue containing a call option, protecting the Treasury from being locked into relatively high rates if yields decline, would be less attractive to potential buyers than the same issue without the call option. 7 FEDERAL RESERVE BANK Two tax characteristics also merit brief discussion. One involves tax-anticipation se curities, which usually mature about a week after a mid-month tax date, but may be sub mitted at par value for payment of income and profits taxes on the earlier date. These are, therefore, convenient abodes for the taxdestined funds of individuals and corpora tions, as well as a major support to the Trea sury in its effort to even out its seasonal cash flows. Finally, there are the so-called “flower, bonds,” which are acceptable at par for estate-tax purposes. Deeply discounted bonds that carry this privilege are in special demand in the secondary market, but the strength of their impact on the primary market is hard to judge. 8 Maturity: b a sk feature Basically, however, the Treasury concen trates on yield and maturity, even though it gives due consideration to all the other char acteristics mentioned above. Given a certain set of economic conditions, the Treasury de cides on a certain combination of price and non-price terms that is estimated to result in a successful sale— that is, one which meets with a fairly enthusiastic response from the public at a price reasonably close to the going rates in the market for the same maturity, and one which meets the Treasury’s objective regarding maturity distribution. Within tolerable expected-yield limits, the maturity is chosen to satisfy the Treasury’s desired maturity structure— one that does not concentrate repayment obligations so heavily in a short period of time as to build in a difficult future financing problem for the Treasury. There are certain limitations, how ever, on the Treasury’s freedom to select the maturities it desires. The archaic (1917) statutory ceiling of 414 percent on long-term Government issues is an anachronism in these days of 6-percent money, yet it has OF SAN FRANCISCO effectively precluded the Treasury from sell ing new issues in, say, the ten-year maturity range on some occasions when such an ex tension of the debt would have been desir able. It has also stimulated the practice of refunding debt through the exchange of ma turing issues for longer-term issues. Though the Treasury might be able to get around the coupon-rate ceiling by selling new securities at a discount, it is loath to issue bonds at the large discounts necessary to bring a long-term bond up to what is, under present conditions, a competitive yield. The Treasury is not just another borrower in the market: its securities play a special role in the economy as a riskless abode for savings. Some critics argue that the sale of long term bonds at the large discounts necessary to bring a 414-percent coupon up to a yield of, say, 6 percent could undermine investors’ confidence; especially that of investors hold ing outstanding long-term issues. In fact, of course, holders of low-coupon bonds during high-interest periods are already aware of the heavy discount in the capital value of these assets; the quote sheets provide the market a daily reminder of this fact. Yet new issues continue to be floated successfully, and high yields — which should raise questions of credit-worthiness every bit as much as deep discounts — seem, thus far, to attract rather than repel investor interest. Ease of selling Another basic consideration in selecting a maturity for a new offering is the relative ease with which it can be sold, considering the current phase of the business cycle. Most apparent of the problems of this kind are the difficulties encountered in se llin g b o n d s, rather than bills, during expansionary peri ods when interest rates are rising—that is, when securities prices are falling—and when the Federal Reserve is attempting to maintain January 1969 MONTHLY a tight-money atmosphere. Although an offer ing of long-terms can be sold when the mar ket is tight by granting commercial banks the privilege of paying for securities through crediting of the Treasury’s tax-and-loan ac count rather than through payment in Fed eral funds, the consequent growth in bank reserves may run counter to Federal Reserve policy. In contrast, selling long-term securities during a particular phase of recessionary periods is a relatively simple matter. When interest rates are falling, marketable secur ities are attractive because of the potential for capital gains as prices rise. Many inves tors have loanable funds available at such times because negative expectations about business conditions deter them from holding equities. Once, however, business conditions turn around and interest rates start moving up, bonds become less attractive than equities and short-term securities, and the Treasury finds it more difficult to undertake bond fi nancing. This phenomenon has probably be come more important in recent years because of the tendency for interest rates to make a fast turn-around at peaks and troughs of the business cycle, partly reflecting money mar keteers’ expectations of changes in Federal Reserve policy. Short-term securities p re s e n t m in im al problems at any time. Though they are easier to sell when interest rates are falling or low, they can also be sold during boom periods because of the demand for liquid assets during tight-money periods. (Short term securities may come into favor as a way of holding funds in anticipation of a reversal of the upward trend of interest rates; the short maturity of the Treasury bill, for ex ample, makes it fairly immune to the risk of appreciable capital loss.) Moreover, the auction technique makes the process of bill financing easier, at all times, for the Treasury. REVIEW H eavy T reasury borrow ing dominates fiscal '68—=-and most earlier years as well Billions of Dollars 1961 Fiscal 1963 Yield: basic feature The yield which the market would produce on a proposed coupon security slated to ma ture on a given date can be estimated on the basis of the existing pattern of interest rates for issues of varying maturities close to that date, allowing for certain qualifying consid erations. One such consideration is the posi tive or negative contribution of the security’s other features to its overall attractiveness, and another is the extent to which the market for issues of that general maturity may be relatively saturated. In order to attract in vestors and assure the success of a flotation, issues are usually “sweetened” by offering a slightly higher yield than is currently prevail ing in the market for similar securities. A coupon issue might be priced to sell slightly above or below par, in order to permit closer pricing than can be achieved with the standard eighths of a percentage point. For bills, or for other securities sold at auction (such as two 1963 bond issues), the Treasury need not worry about selecting a price— the bidders do it themselves, and competitive pressures keep the yield close to the market. 9 FEDERAL RESERVE BANK Techniques of timing During the 1960-61 period, two unique refinancing techniques were introduced by the Treasury— advance refunding and cash refunding. These innovations represented de partures from the traditional exchange opera tion— the first, in respect to the timing of the refunding, and the second, in respect to the elimination of the “rights” feature of matur ing securities as the exclusive means of ob taining newly offered issues. The first of these innovations, advance re funding, involves the offer of a new (or re opened) and relatively longer maturity for outstanding securities that are still months or years from final maturity. (In October 1960, for example, 3 Vi -percent bonds of 1980, 1990, and 1998 were offered for outstanding 2Vi -percent bonds first callable in 1962, 1963, and 1964.) The Treasury has a num ber of objectives in conducting an advance refunding, but the principal goals are the ex tension of the outstanding debt and the altera tion of the debt’s maturity, by opening up short or intermediate slots in the maturity structure in which the Treasury may place new issues in subsequent cash or exchange offerings. The term “pre-refunding” eventually came into use in connection with advance refund ings where the eligible issues for which new securities have been issued have less than one year to run to final maturity. On occasion, a regular exchange-refunding operation may include securities with a few months of re maining maturity along with the issues falling due immediately. The second financing innovation, cash re funding, involves the selling of new securities in order to pay off maturing issues in such a 10 OF SAN FRANCISCO way as to diminish the danger of attrition associated with the traditional exchange tech nique. Attrition frequently results from the tendency of security holders to cash in all or part of their securities at maturity, no matter what the exchange offering includes. The Treasury has difficulty knowing precisely be forehand what proportion of any outstanding issue will be turned in for cash, and thus it has difficulty in projecting its cash needs ade quately. The success of an exchange offering de pends on the mood of the market— on such factors as whether security prices are rising or falling— and on the distribution of the matur ing issue among different types of investors. Any security as it nears its maturity date be comes a highly liquid short-term instrument, and thus it often moves into the hands of in dividuals who need or desire such instru ments. Since many of these individuals require cash at the time their holdings mature, the success of a straight exchange offering is sometimes sharply limited. Moreover, to the extent that other holders wish to stay on the liquid end of the maturity spectrum, the range of possible maturities the Treasury can suc cessfully offer in an exchange is further lim ited. But by raising cash to pay off a matur ing issue, the Treasury can approach a broad er class of investors and perhaps choose from a greater range of maturities, as well as main tain better control over the maturity struc ture of the debt. So much for the technical tailoring of a proposed issue to the market in which it is to be sold. The next section highlights some of the specific practical problems faced by debt managers during the deficit decade of the ’60s. January 1969 MONTHLY REVIEW 01. Affinals of the Decade The nation’s debt managers have faced a wide range of problems during this decade of uninterrupted growth in the American econ omy. Beginning in 1961, the nation has moved from recession to recovery to full em ployment, and then on to wartime boom and inflation. Each stage implies its own particu lar difficulties in the way of financing Federal deficits— and there has been a deficit in each of these years, building up to the postwar record deficit of fiscal 1968. Initially the deficits were caused by auto matic stabilizers acted upon by recessionary forces; with given tax rates Federal revenues declined as incomes fell away, while Federal expenditures increased for such commitments as unemployment compensation. Later the deficits were associated with a discretionary fiscal policy aimed at stimulating economic growth. Most recently, however, the Trea sury’s problems have been compounded by high government spending in a rapidly ex panding economy which, however, failed until June 1968 to generate offsetting tax rev enues. Thus, the internal configuration of the economy has influenced the nature of the Treasury’s task. Throughout the current dec ade, moreover, the urgent problems of the external balance of payments have also had a bearing on debt-management policy. May 1960 saw the peak of the recovery from the 1957-58 recession and the com mencement of the mildest of the postwar recessions. The debt managers’ task was eased by the absence of inflationary pressures, but it was complicated by the existence of international financial pressures. Specifically, the movement of short-term capital abroad in response to the pull of relatively high short-term interest rates in foreign money centers aggravated the U.S. balance-of-payments deficit. In this situation, debt-management policy sought to maintain a supply of short-term instruments sufficient to keep domestic short term interest rates high relative to those of our competitors in the international money market. The Federal Reserve’s role mean while was to try to keep long-term rates rela tively low, in order to stimulate capital in vestment in the domestic economy, while maintaining short-term interest rates at a high enough level to assist in the amelioration of our international payments difficulties. FEDERAL RESERVE BANK FY '61: innovations As a consequence of these “Operation Twist” policy specifications, the Treasury in 1961 concentrated its financing in the short end of the money market; most of the cash financing consisted of bills with maturities ranging from 3 to 12 months. Devotion to short-term money-market instruments was imperfect, however, as indicated by the re sort, during the year, to three notes with ma turities ranging up to two years. The 1961 financings were of added impor tance because of the adoption of two financ ing innovations. The cash-refunding tech nique, described above, was introduced in early 1961, and has accounted for a large part of the Treasury’s cash-financing opera tions ever since. In June, the Treasury adopted the year’s second innovation, the strip-of-bills tech nique, with one auction of an additional $100 million of each of the outstanding regular weekly bills maturing August 3 through No vember 30. In this auction, unlike the regu lar weekly auction, banks were permitted to use tax-and-loan account credit in payment. By using this technique, the Treasury was able to raise a large amount of money quickly instead of through gradual additions to the regular bill series. In consequence, the stripof-bills procedure was resorted to on several occasions during ensuing years. 12 FY !62: longer terms In October, the precepts of “Operation Twist” were further diluted when the Trea sury offered an additional $2 billion of the 3XA -percent notes maturing May 15, 1963. This came on the heels of a change in Trea sury financing plans because of the expecta tion that the usual seasonal cash surplus would not appear in the second half of fiscal 1962. So, instead of relying primarily on a June tax-anticipation bill, the Treasury was forced to do some of its financing in longer OF SAN FRANCISCO maturities. The notes were sold at a slight discount from the original par price, and banks were allowed to make up 70 percent of payment through tax-and-loan account credit. The new notes were oversubscribed and, with a 37 percent allotment ratio, total allotments were also permitted to exceed by $295 m illio n the amount originally an nounced. In January 1962, in an environment char acterized by a monetary policy of decreasing ease, the Treasury made its first cash offering of a bond since April 1960. Response to this $1-billion reopening of the 4s of 1969 was not overly enthusiastic, as the relatively high (60 percent) allotments indicate. Al though the issue sold at a discount and car ried an attractive tax-and-loan account privi lege, potential buyers may well have been viewing the future likelihood of higher inter est rates— already foreshadowed by a recent increase, to 4 percent, in permissible ceiling rates on savings deposits. In the earlier (recession) situation, most pressures on policy had been in the direction of short-term financing. As the economy moved upward, however, the debt-manage ment problem became more complicated. Anti-inflationary considerations emerged and led to the usual recommendation that financ ing of the deficit should be done through tap ping the savings of the public rather than through the expansion of bank credit. On the other hand, the domestic expansionary part of Operation Twist’s objectives precluded the Treasury from pushing ahead too far with long-term financing. A balance had to be struck between the risk of feeding inflation by promoting over liquidity and the risk of stunting the expan sion before the economy reached “full em ployment.” Financing through longer-term securities would minimize the first but in crease the second risk. Financing in the short end of the market— and thus avoiding com petition for long-term funds that might other January 1969 MONTHLY wise go into private investment— would mini mize the second but increase the first risk. That alternative would also have the virtue of holding up short-term rates. As a consequence of these somewhat con flicting considerations, the Treasury con tinued to raise new cash through the sale of short-term securities in an attempt to keep the pressure off long-term markets until the recovery progressed further. And even so, it tried to maintain the debt structure through the use of advance refunding and pre-refund ing techniques. FY "63: bond auctions One of the major innovations during this period was the development of the auction method for selling bonds, which was attempt ed first in January and then in April 1963. The offerings involved competitive bids by underwriting groups which agreed to make a bona-fide public reoffering. Each group made a single bid for the total amount, and the A v e r a g e m a t u r it y of debt drops during Vietnam period, with financing heaviest in short end of spectrum Billions of Dollars Fiscal REVIEW entire issue went to the highest bidder. In each case there was a choice offered as to coupon rate, but the award was based on the net yield. The sales were a great success from the Treasury’s viewpoint of minimizing interest costs; the technique lent itself to the pricing of an issue very close to the state of the market. On the other hand, the two issues met considerably different receptions when reoffered to the public. The first issue was picked up immediately and went to a pre mium of more than % point; the second issue came into a somewhat unsettled market and some of the underwriting partners had difficulties disposing of their allotments at the original resale price. Thus the under writer-auction method did not turn out to be quite the optimal solution to the Treasury’s continuing problem of issuing securities. FY "64: debt lengthening The money-managers’ policy objectives in fiscal 1964 were roughly the same as in the previous year: to finance the deficit in a noninflationary manner while keeping the econ omy expanding toward “full employment” and, at the same time, while keeping short term rates competitive with those abroad so as to prevent the outflow of volatile funds. The urgency of the payments constraint was evidenced by the July 1963 discount-rate in crease, which was aimed primarily at stem ming the outflow of short-term capital— and more directly, by the adoption of the interestequalization tax. Yet, Administration pro nouncements that the line would be held on long-term interest rates evidenced a concur rent attempt to wrangle both horns of the dilemma. During fiscal 1964, net cash borrowings by the Treasury amounted to $3.9 billion — a marked decline from the performance of the two preceding fiscal years. Once again, how ever, the emphasis was on financing through regular bill issues: during the year, regular FEDERAL RESERVE BANK weekly and one-year bill maturities rose by $3.5 billion, and $2.5 billion of that increase occurred in one-year offerings as these bills moved to a monthly schedule from their for mer quarterly dates. By this step and by avoiding one-year coupon issues, debt man agers were able to put more of the one-year debt on an easily-handled rollover basis. The enlargement of bill issues — and the expansion of the national economy— helped hold up the short-term interest rate during most of the year, despite the heavy reduction of outstanding issues (other than bills) ma turing within twelve months. Indeed, to avoid over-liquidity in the economy, the Treasury reduced such issues by $7.4 billion and thus brought about a net decline in the total mar ketable debt in this maturity range. Pre-re fundings were used to this end; in two sep arate operations, holders of $5.9 billion in issues due within a year accepted pre-refunding offers of issues ranging in maturity from 5 years 2 months to over 30 years. 14 FY '65: more advance refundings During 1964 and 1965, the balance of payments showed signs of improvement and the economy, under the stimulus of the 1964 tax reductions, moved to its interim goal of 4-percent unemployment. Yet, with the approach to “full employment,” the infla tionary tendencies of the economy became more pronounced and interest rates began to rise more rapidly. Then, of course, the Vietnam war began to exert a major impact on financial markets by late 1965. During fiscal 1965, long-term securities be came increasingly difficult to sell as interest rates rose to levels that made the 4 X A -percent statutory limit an effective deterrent to bond offerings at par. This forced the Treasury to rely on exchange-refunding operations in its efforts to maintain the debt structure— and in this it was fairly successful. Each of the two major advance-refunding operations (July 1964 an d J a n u a ry 1965) placed large OF SAN F R A N C IS C O amounts of debt in long-term sectors. At the same time, a substantial increase occurred in the within-one-year category, while an even more substantial decline took place in the one-to-five year class. FY '66: escalation Impact Treasury objectives were re-weighed in mid-1965 as the Vietnam conflict became the main influence on the economic climate. In terest rates began to climb, and budget def icits began to expand, with increasing rapid ity. The Treasury was forced to modify its debt-lengthening goals, and Operation Twist ceased to be a functioning policy as “condi tions” came to rule actions. The aim of the debt managers came to be that of selling longs whenever possible— but this was simply not possible. In fiscal 1966 and later, Treasury bills in creasingly became the mainstay of the cash raising process. Previously this was a mat ter of choice, but now it was a matter of ne cessity: “In the period prior to June 1965 Treasury bill issues were increased in part to keep U.S. short-term rates competitive with those abroad, but during fiscal year 1966 the bill market was used because this area could most readily absorb the added borrow ing.” (Treasury Annual Report) The difficulties involved in selling longerterm debt instruments went beyond the boom ing private demands for funds, since agency issues also competed with Treasury issues for available financing. During the last half of fiscal 1966, Federal agencies borrowed over $5 billion in new money. These obli gations, many of which had fairly short ma turities, were able to draw off a substantial amount of investment funds, especially since they could boast both attractive yields and a minimum of risk. Net cash borrowing by the Treasury dur ing fiscal 1966, totalling $2.6 billion, was down to its lowest level since 1961, with $1.3 billion in new cash being raised by additions January 1969 MONTHLY to regular weekly Treasury bill sales and most of the remainder being raised by tax-antici pation bills (TABs). In order to attract com mercial-bank buyers in an uncertain market, the Treasury allowed them to make full pay ment for TABs in tax-and-loan account cred it. The Treasury thus obtained some savings in the form of lower interest rates, but at the cost of furious competition for Treasury de posits in a tightening monetary environment. Two short-term cash offerings were made in this period, one involving an 18-month, 4 Vx -percent note and the other involving a 10-month, 4 % -percent certificate with, taxand-loan account privilege. The strong re ception accorded the latter attests again to the importance of the T&L privilege during periods of monetary restraint and rising in terest rates. The note offering (N o v e m b e r 1965), which was conducted to pay off $9.7 billion of maturing securities, utilized the cash-refunding technique because of the fear that an exchange refunding might result in a high rate of attrition. Although Treasury-preferred lenders (such as states and pension funds) held a large proportion of the maturing issues, the new offering came to market just at a time when business was vigorously expand ing and interest rates were trending sharply upward. This 414-percent coupon issue was sold at a discount to yield 4.37 percent— roughly 10 basis points above current market yields and the highest yield paid on a Treasury coupon security since 1960. Moreover, the Treasury offered to allot in full subscriptions up to $200,000— an unusually high figure. With all that, the offering failed to elicit a vigorous subscription response. The allotment on the nonfavored subscriptions was 48 percent, a figure far higher than market expectations and unequalled or even closely approached in recent experience. As a result, the govern ment market sagged until rescued by Federal Reserve purchases of the “when-issued” se REVIEW curities. ( “When-issued” trading consists of purchases and sales in advance for the de livery of securities after they are issued.) The 10-month c e rtif ic a te s of January 1966, in contrast, were sold with tax-and-loan account privilege granted for as much as full payment. The offering was small, $114 bil lion, and priced to yield 4.85 percent on a 434 -percent coupon— and it received an en thusiastic response despite the uncertain tone of the market. Subscriptions totaled over $10 billion and resulted in a 1414-percent allotment ratio with a $50,000 cut-off on full allotments. Despite the difference between a $9.7billion 18-month offering yielding 4.37 per cent and a $1.5-billion 10-month offering yielding 4.85 percent, the dissimilarity of market response to the two issues was so evident as to suggest the overriding influence of the T&L-account privilege. On general grounds, the certificate offering should prob ably have evoked a much weaker response. The announcement of that offering mention ed future additional financings to meet the unexpected costs of Vietnam, thus confirm ing many fears of future deficits and infla tionary pressures, and an upward trend in interest rates had already been signaled by the December rise in the discount rate. Though the market might have previously discounted all of these possibilities, the certi ficates’ better reception was probably due to more than just a stronger market. FY "67s mixed +rends In fiscal 1967 (and 1968 as well), Trea sury policy in essence continued along the lines set forth during fiscal 1966. A major part of the new cash needed to meet wartime deficits was raised through additions to reg ular three-month, six-month and one-year bill series, and through monthly auctions of a new nine-month series along with the usual one-year bills. FEDERAL Throughout this pe riod, the Treasury for sook some of its aims with regard to the debt structure in order to get money when ever it possibly could, but meanwhile it tried to take maximum ad vantage of the course of short-term move ments in interest rates and m o n e y -m a rk e t conditions. With all securities markets in continual states of tu mult, debt m anage ment was a difficult task at best. 16 RESERVE BANK SAN F R A N C IS C O S lM r p Iner@os@s in interest rates reflect intense pressures on security markets from Treasury, other borrowers State-Local Bonds Treasury B ills ( 3 - M o n t h ) B illio n s of D o lla rs Even so, fiscal 1967 financings were gener ally successful, reflect ing the gradual easing in the money market after September. The Treasury decided to take advantage of this _|0 situation and, in Octo ber 1966,announced a cash refunding involv ing $2.5 billion of 5% -percent 15-month notes and $1.6 billion of 5% -percent fiveyear notes. This offering met with an en thusiastic response, and oversubscription led to allotments of 10 percent on the five-year issue and 30 percent on the shorter security. The cash refunding of February 1967 ma turities was also successful. The offering again consisted of a 15-month note and a five-year note, but considerably more ($7.5 billion) was to be raised, and considerably less was to be paid for the offering, with 4% percent coupon rates e q u a llin g effective yields of 4.85 percent for the short note and 4.84 percent for the long note. During this OF period when fears of current or impending recession were rife, money-market conditions had eased and the outlook for fixed-yield equities was bullish. The yields on the notes thus were considered generous, and, in fact, dips in the market just before the offering aroused fears that speculators might be at tracted by the premium yield. Despite the lack of tax-and-loan account privilege for either issue, the subscription was very heavy; allotments were 10 percent on the 15-month note and 7 percent on the fiveyear issue. The notes opened at substantial premiums in “when-issued” trading, and they remained above their original prices even January 1969 MONTHLY though the market was moving downward under the pressure of a heavy calendar of cor porates and municipals. This heavy pressure from corporate and municipal securities led to declining prices for longer-term governments from January 1967 on. Prices on new Treasury bills, on the other hand, did not begin to decline until the end of the fiscal year, after which time they began to move parallel to the prices of other Treasury issues. The six-month diver gence in the direction of price movements of short- and long-term securities reflected, to an important degree, speculation in financial markets that tight money would return in the fall or winter. In order to provide a liquidity hedge against such a contingency, a consider able amount of long-term borrowing was un dertaken in the spring months and ware housed temporarily in Treasury bills. F Y ”68: reco rd deficit With the beginning of fiscal 1968, the Treasury stepped up its borrowing as it tried to deal with the heavier-than-expected costs of Vietnam and Congress’ unwillingness to pass the President’s requested tax increase. Facing a net transactions deficit of $19.5 bil lion in July-December 1967, the Treasury found it necessary to go into the market with $8.5 billion in tax-anticipation bills, with $2.9 billion in additions to regular bill series, and with two note offerings for $4.5 billion of new cash. Most of the rest of the trans actions deficit was met by a moderate de crease in the Treasurer’s account and by sales of $2.5 billion of agency securities and par ticipation certificates. The fiscal ’68 note offerings failed to meet with the success of the several preceding op erations. With prices of governments in a general decline during this period, the Trea sury could not sell any substantial quantity of intermediate-term notes — much less long term bonds, which it undoubtedly would REVI EW have preferred to sell if the statutory interestrate ceiling had permitted. The $9.6-billion refunding of August ma turities was handled through a cash offering of a like amount of 15-month 5 Va -percent notes, yielding 5.30 percent at the discount ed price. The cash-refunding method was used— most probably out of the wish to avoid attrition, and also out of the hope that heavy subscriptions might take place, permit ting an over-allotment to raise some net new cash. Entering the market at the end of July, the Treasury received subscriptions totaling only $15.7 billion. After full allotment of small subscriptions and exchanges for preferred lenders, the allotment ratio was 35 percent, near the high end of the range of market ex pectations, and the over-allotment was but $300 million. The offering was followed im mediately by a decline in prices of govern ments, including the new issue. The 3 Vz -year 5 % -percent notes offered later in August to raise $2.5 billion in new cash were even less successful. Though banks had the privilege of paying for the securities through tax-and-loan account credit, sub scriptions were not heavy and a 3 8-percent allotment resulted. This issue also moved quickly to a small discount. Here the T&L privilege proved to be only a limited entice ment because the funds were not expected to remain long with the banks; even so, com mercial banks still became the major sub scribers, as the notes seemed to be priced sufficiently below the market to permit prof itable underwriting. The November 1967 refunding of $10.2 billion in securities would have greatly tested the ingenuity of the debt managers, faced as they were with a descending trend in market prices, even if they had not needed more new cash. They decided on a cash offering be cause it could be geared to raise the addition al funds required and, as usual, because it FEDERAL RESERVE BANK would avoid attrition. Two notes were of fered: a 15-month $10.7-billion issue carry ing a 5 % -percent coupon, and a unique seven-year $ 1.5-billion note with a 5 3A -per cent coupon. The latter was the first note issued under recently approved legislation extending the “note” range up to seven years, thus avoid ing th e c o n tin u e d b a n a g a in s t sales of “bonds” with coupon rates greater than AVa percent. Though the amount involved was small, it represented the Treasury’s first ef fort in some time at reversing the shortening trend of the debt structure. But with this issue, as with the August 1967 offering, it was not possible to offer tax-and-loan priv ilege due to the refunding character of the operation. The seven-year note attracted considerable speculative interest due to its novelty and to its 5 % -percent coupon. The attractiveness of this high rate created fears that the issue might draw substantial funds out of savings institutions — and thereby weaken the resi dential-construction industry, which is heav ily dependent on savings institutions for mortgage financing. But the generally nega tive tone of the market eventually prevailed, following allotments of 36 percent on the short note and IV 2 percent on the long one, and the securities fell to significant discounts in when-issued trading. In fact, the govern ment market sagged in all maturity sectors OF SAN FRANCISCO during November, largely because of the tightening monetary policy necessitated by the British devaluation. The market rallied from the mid-Novem ber lows until mid-January, when it began a zig-zag, slightly downward pattern. During this brief period of relative stability, the Treasury made an exchange offering of $5.1 billion of another 53A -percent, 7-year note, and attempted to meet new cash needs by issuing $4 billion of 15-month, 5% -percent notes, along with almost $1 billion obtained from additions to weekly and monthly bill series. This stability proved all too ephem eral, however, in the light of the nation’s domestic and international problems, includ ing the problem of a burgeoning Federal deficit. The 5 % -percent notes issued in February carried 100-percent tax-and-loan privilege, thus stimulating commercial-bank underwrit ing of the issue. The privilege was worth per haps 15 basis points of yield for the average bank, and probably m ore than th at for smaller banks, with their lower reserve re quirements and longer periods of holding deposits. The 39-percent allotment on sub scriptions exceeding $200,000 was generally in line with expectations. Moreover, the issue maintained its price in the after-market — which prevails after the security is issued and while underwriters are moving their inven tories into the hands of more permanent investors. Considering the difficult economic environ ment, and considering that this was the larg est new cash-financing operation in the cou pon market in over a decade, the offering was actually quite successful. It failed to meet the objectives of lengthening the structure of the debt and curbing the liquidity of the econ omy, but under the circumstances, the Trea sury probably had no alternative. A cash financing in May, like the one in February, was conducted in conjunction with MONTHLY January !% 9 a 7-year exchange refunding, this time for $6.7 billion at 6 percent. In this cash financ ing, $3 billion of 15-month notes were of fered with a 6-percent coupon, reflecting the February-to-May downtrend in prices of gov ernments. The yield was generous in com parison with the market-yield curve, and an additional attraction was the 100-percent tax-and-loan privilege, but all this seemed necessary in light of the many uncertainties facing the money market. Oversubscription was heavier this time, yielding a 28-percent allotment on subscrip tions exceeding $100,000, and this permitted a $366-million overallotment as compared with the $277-million overallotment in Feb ruary. Still, the issue’s reception in a market REVIEW affected by war and surtax uncertainties gave a mixed picture: the security traded at a slight discount on a when-issued basis and fell further immediately after issuance. The Treasury’s additional cash needs dur ing the last quarter of fiscal 1968 were met through $2.1 billion of additions to weekly and monthly bill series. Thus, for the year as a whole, outstandings in the under-one-year category jumped by $16.8 billion— the larg est such increase since fiscal 1953. Not sur prisingly, then, the average length of the debt dropped to four years and two months at the end of this period, as compared with five years and four months at the end of fiscal 1965, the high-point for this decade. Michael Prell This report on Treasury debt management was prepared under the general supervision of Herbert Runyon. Publication Staff: R. Mansfield, Artist; Karen Rusk, Editorial Assistant. Single and group subscriptions to the M onthly Review are available on request from the Admin istrative Service Department, Federal Reserve Bank of San Francisco, 400 Sansome Street, San Francisco, California 94120 Credit— and Credit Cards Credit-card activity continues to increase throughout the nation, but the West still dominates the field, just as it has from the very outset. The booklet, Credit— and Credit Cards, reviews some of the recent developments in this rapidly moving field, in a revised version of material which first appeared in the September 1968 Monthly Review. Copies of this publication are available upon request from the Administrative Services Department, Federal Reserve Bank of San Francisco, San Francisco, California 94120. FEDERAL RESERVE BANK OF SAN FRANCISCO Western Digest Rising Interest Rates The Federal Reserve Bank of San Francisco, along with the other eleven Reserve banks, raised its discount rate from 514 to 5 Vi percent during the week of December 16. The Federal Reserve Board approved the increase “in recogni tion of the advances that have taken place in other market interest rates in recent months and also in light of the resurgence in inflationary expectations that is im peding the restoration of economic stability.” . . . Hard on the heels of the Federal Reserve action, the nation’s major commercial banks increased their prime lending rate from 6 V2 to 6 3A percent. Then, in early January, the banks again raised their rate to prime commercial borrowers, this time to 7 percent. They attributed this increase to the heavy borrowing demand of business and consumers, as well as the rapidly rising cost of funds to the banks. Falling Aerospace Employment The employment decline in the Western aerospace industry continued during the fall months. Payroll employment in the regional industry totaled 718,000 at the end of November— down 40,000 since the beginning of 1968. . . . Sluggish activity in the industry reflected the 3 percent decline, to $7.8 billion, in the volume of military contracts awarded to District firms during fiscal 1968. Contract awards for missiles and space systems actually rose during this period, primarily for new research-and-development work, but these gains were more than offset by cutbacks in electronics and communication work and in shipbuilding. Zooming Lumber Prices Lumber prices continued to rise sharply in December, mostly in response to the heavy demand from wholesalers for 1969 construction needs. Price quotations for ponderosa pine and Douglas fir were up 40 to 50 percent above year-ago figures. . . . At this point, the National Association of Homebuilders asked the Presidential Committee on Price Stability to study the situation “with a view toward restoring lower price levels.” In addition, two major lumber firms attempted to roll back some of the recently-posted price increases, but their efforts were frustrated as the rest of the industry continued to quote higher prices. Winter Crop Damage Falling temperatures caused moderate-to-heavy damage to the District’s citrus and winter vegetable crops in late December. The crop damage brought about some strengthening in prices, which had tended to weaken earlier in the face of potential bumper crops. . . . Severe late-January storms also caused some damage to California crop areas, but the destruction was concentrated in urban areas, with 90 deaths and $35 million in property damage reported.
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