The Credit Crisis: U.S. Treasury Securities

It's been a long time coming, and here is the third installment of a look at the so-called "credit crisis". In earlier posts, we explored LIBOR rates and the Fed funds rate. To recap the previous two articles in brief, LIBOR and the effective Fed funds rate are both rates for the interbank lending market. Recall that banks may find themselves with excess reserves which they want to lend on a short-term basis to make a profit. Instead of lending to another bank, they may choose to provide a short-term loan to the federal government.

This is where the U.S. Treasury market comes in to play. We all know that the U.S. government is running a massive deficit and has a large outstanding debt. Most of this deficit is funded via U.S. Treasuries and the debt is largely composed of outstanding Treasuries. However, the government does use Treasuries for more than funding the deficit. They are also important to fund basic government operations.

Like many individuals and businesses, the federal government does not receive cash at the same time it needs to spend cash. As such, borrowing money on a short-term basis is required. This is a very acceptable role in the economy to be provided by financial services companies. While a budget may be in balance, cash flows are not always the same. Consider the following graph which shows the average monthly levels of receipts (mostly tax revenues) and outlays (government spending) for the federal government.

Source: Monthly Treasury Statement - Financial Management Service, Department of the Treasury

The y-axis on the above chart is an index where 100 is the equivalent of an average month in terms of either receipts or outlays. In this data, the both sides of the budget are normalized and then averaged to ignore deficit levels and illustrate the seasonality of cash flows. The large red spike in April indicates that the government receives 60% in receipts than an average month (think tax season). You can see that receipts are far more volatile than outlays. This leads to a cash flow management problem which leads to the issuance of Treasury Securities.

The Bureau of Public Debt, a division of the U.S. Treasury, is responsible for issuing new government debt to fund both the deficit and cash flow issues. This is done via regular auctions by TreasuryDirect where a specific debt offering is bid upon competitively. Most Treasury Securities are offered at maturities of three or six months. This is consistent with the government's need to manage cash flows. Once the Treasuries are purchased in the auction they are often traded in the secondary market.

This is where the banks come in to play. First of all, banks are among the most active participants in the aforementioned auctions. They are also very active in trading these Treasuries amongst each other in the secondary market. When a bank has temporary excess cash reserves which they wish to lend, they have two basic choices: lend to another bank or purchase short-term Treasuries on the secondary market. The government is considered a lower credit risk than banks, so Treasuries generally trade at a lower effective interest rate than either LIBOR or the Fed funds rate. (Comparisons will be made in a future article.)

The below chart shows the history of the 3-month Treasury Bill (which is most commonly used in comparisons with the interbank lending markets) since 1954:

Source: St. Louis Federal Reserve

And this chart zooms in since 2001:

Much like the other rates we have looked at have reviewed previously, 3-month Treasury Bills are at historic lows. As we discussed in looking at LIBOR, context is important when looking at interest rates. The relationship between LIBOR, the Fed funds rate, and Treasury Bills are important and speak to the interbank lending markets. We'll look more closely at these relationships in the next installment in the series.