The Return of the 30-year Bond

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Commentary from Dr. Kellner at MarketWatch:
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One more time
Commentary: Just in time, the return of the 30-year bond

By Dr. Irwin Kellner, MarketWatch
Last Update: 9:58 AM ET Aug. 2, 2005

HEMPSTEAD, N.Y. (MarketWatch) -- The revival of the U.S. Treasury's 30-year bond, expected to be announced on Wednesday, is just what the doctor ordered. It was also inevitable.

Back in October 2001, when the Treasury stopped selling this issue, the government's fiscal outlook was bright. Although the budget surplus was shrinking under pressure of the ongoing recession, virtually no one expected it to disappear and be replaced by record deficits starting as early as 2002.

That being the case, it made sense from the government's perspective not to lock itself in to high interest rates by issuing long-term debt. After all, surpluses "as far ahead as the eye could see" would logically be expected to result in lower interest rates across the board.

The shape of the yield curve provided an added bonus.

Having been negative in the last few months of 2000, the curve turned steeply positive starting in early 2001, as the Federal Reserve began the first of what subsequently became 13 rate cuts in 2-1/2 years' time. This provided an added inducement for the Treasury to shorten up the average life of its debt.

But as any forecaster will tell you, things don't always turn out as predicted.

The recession, combined with several tax cuts and stepped-up spending on defense and homeland security in the wake of the Sept. 11 attacks, sent Washington's budget deeply into the red - creating a problem for the government's debt management.

Just as Washington's debt started to grow faster than the economy, its average life began to shrink. As a consequence, the Treasury had to go to the markets with increasing frequency to roll over its existing debt while it borrowed new funds.

This had the potential to lead to higher interest rates, more inflation, or both, depending on how much of these funds came from the public and how much from the Federal Reserve (which, by adding to the money supply, allows inflation to fester).

To be sure, the government missed a golden opportunity to lock in historically low interest rates back in the spring of 2003, when rates were at 45-year lows and deflation fears filled the air. Long-term rates had a three-handle around the middle of that year.

But it's better late than never. Long-term rates are still relatively low, while the demand for a long-dated government issue is strong.

Since the passage of Sarbanes-Oxley, many pension funds and other entities both public and private are looking for ways to match assets with liabilities without the uncertainty of investing in equities.

There's an added bonus: by stretching out its borrowing requirements, the Treasury will take some of the pressure off the short end of the market, even as the Federal Reserve is adding to it by boosting its federal funds rate.

This will help keep short-term rates below long rates, thus maintaining a positive slope to the yield curve for a longer period of time than might otherwise be the case.

And as everyone knows, a positive yield curve is the best medicine against the onset of a new recession.