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Betting Big On Low Yields


When the U.S. Treasury shocked the financial markets in October, 2001, with the announcement that it was ending the sale of 30-year bonds, it gave two main reasons for the move. It argued that the government's finances had improved to such an extent that 30-year bonds were no longer necessary. It further contended that the government could save money by not issuing higher-yielding long bonds.

Now, says Assistant Treasury Secretary Timothy S. Bitsberger, "it's a different world." Indeed. On May 4 the government announced that it may resume sales of 30-year bonds early next year. If so, the Treasury will be betting that long rates will remain low, allowing it to put a lid on the government's borrowing costs.

It's a risky bet since no one, Federal Reserve Chairman Alan Greenspan included, can fully explain why long-term rates have remained so low. But the move reflects a belief that the world is awash with excess savings that will last for some time as aging baby boomers in Japan, Europe, and the U.S. stash away money for retirement. "Treasury is taking the view that we've entered an extended period of low global bond yields," says Louis Crandall of consultant Wrightson ICAP LLC.

At the same time, the government's finances look a lot worse than they did in October, 2001. Thanks to stepped-up spending on defense and homeland security and President George W. Bush's big tax cuts, the deficit swelled last year to a record $412 billion. While it's expected to decline this year as the recovering economy boosts federal tax receipts, the legacy of past deficits means the Treasury will face heavy financing needs for years.

That's partly the result of the Treasury's earlier decision to end issuance of 30-year bonds and increase sales of shorter-dated notes. Those notes -- principally of three- and five-year maturities -- come due sooner than bonds and must be refinanced. Economist Drew T. Matus of Wall Street broker Lehman Brothers Holdings Inc. reckons the Treasury will face an annual financing burden of close to $950 billion by 2008 as a result.

While there's no argument that the government faces some steep borrowing demands in the years ahead, it's not clear that bringing back the 30-year bond will save taxpayers money. Historically, the interest rate on the 30-year bond has been well above that of the 10-year note as lenders have demanded a premium to compensate for taking on extra risk. That's a big reason why Treasury officials stopped issuing long bonds 3 1/2 years ago. They wanted to save money by borrowing at the lower rates available on shorter-dated securities.

ASIAN SELL-OFF

But in recent months the spread between the yield on the 30-year bond and a 10-year note has narrowed markedly, making it more attractive to borrow long term. The collapse in the yield spread has been driven in part by increased buying by U.S. and European pension funds, which are under regulatory and other pressure to shore up their finances by more closely matching the maturity of their assets with their longer-dated liabilities. It's those buyers that Treasury hopes to tap by resuming long-bond sales. Such a shift could also help insulate the U.S. Treasury market from cutbacks in buying of shorter-dated paper by Asian central banks seeking to diversify their currency reserves out of dollars.

It's not just higher demand from pension funds that's behind the low long-bond yields. Lack of supply has also played a part. That's about to change. Indeed, the yield on the Treasury's longest-dated bond, which matures in 2031, rose to 4.59% after the announcement, up from 4.48% the day before.

Long rates have also been held down as hedge funds and others have bought bonds, gambling that the Fed will raise short-term rates slowly. But the strategy could backfire, pushing up long-term rates if the Fed gets more aggressive about tightening credit. In that case, Treasury may have some hard thinking to do before it decides to reissue 30-year bonds.

By Rich Miller in Washington


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