How The Treasury Decides Where To Borrow | Steve Hou on Maturity Issuance Policies of U.S. Treasury and Equity Index Construction
Monetary Matters with Jack Farley
Deep Dive
What is the 'supply effect' in the government bond market, and how does it relate to stock/bond correlation?
The 'supply effect' refers to the impact of issuing long-term bonds on bond yields, which depends on how bonds co-vary with other assets like stocks. When stocks and bonds are positively correlated, bonds add risk to a portfolio, and investors demand higher yields for absorbing bond supply. Conversely, when stocks and bonds are negatively correlated, bonds act as a hedge, and the supply effect is muted, potentially leading to lower yields even as supply increases.
How does the U.S. Treasury decide where to issue debt on the yield curve?
The U.S. Treasury aims to fund the government at the lowest cost to taxpayers. It considers the yield curve and the 'supply effect,' which measures how much yields rise when issuing debt at specific tenors. Historically, the Treasury adjusts issuance based on market demand, liquidity needs, and the weighted average maturity of the debt portfolio. During recessions, it issues more short-term bills to meet liquidity demand, and as the economy recovers, it extends maturity to manage rollover risks.
What are the key findings from Steve Hou's research on Treasury debt issuance?
Steve Hou's research highlights four stylized facts about Treasury debt issuance: (1) about half of the issuance decisions involve adjusting the amount of short-term bills, (2) the Treasury spreads long-term debt issuance across tenors to maintain liquidity, (3) the weighted average maturity of issuance lengthens in response to rising funding needs, and (4) there is a historical positive correlation between issuance maturity and term spread, meaning the Treasury often issues long-term debt when term premiums are highest.
Why does the U.S. Treasury issue long-term debt if it doesn't face meaningful rollover risk?
The U.S. Treasury issues long-term debt primarily to meet market demand and maintain institutional prudence. While the U.S. government doesn't face significant rollover risk due to its credibility, issuing long-term debt helps avoid operational accidents and spreads out maturities. Additionally, the market demands long-term debt for liquidity and trading purposes, which the Treasury accommodates to ensure smooth functioning of the financial system.
What is the 'innovation factor' in equity indices, and how is it captured systematically?
The 'innovation factor' in equity indices is captured by screening companies with persistent growth in R&D expenditures over three consecutive years. This approach focuses on the persistence of innovation rather than the intensity of R&D spending. Companies that consistently invest in R&D tend to outperform, and this factor has historically overlapped with indices like the NASDAQ, which is known for its concentration of innovative companies.
What is the 'pricing power index,' and how is it constructed?
The 'pricing power index' systematically captures companies with strong pricing power by analyzing the stability of their gross margins over the trailing five years. Companies that maintain stable gross margins are likely to pass on cost increases to consumers or supply into increased demand, indicating strong pricing power. This index tends to include niche suppliers in specialized industries, such as AI-related companies, rather than large-cap tech firms like Apple or Nvidia.
What is Steve Hou's macro view on the current economic environment and asset allocation?
Steve Hou believes the U.S. is in an environment similar to the dot-com bubble, where stock market mania could overshadow macroeconomic factors like inflation and bond yields. He expects a potential repeat of the dot-com playbook, with a stock market surge followed by a crash and recession. In this scenario, bonds could become more attractive during a market downturn, but the secular trend points to a bearish outlook for bonds due to inflation and rising debt levels.
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