Wednesday, May 2, 2012


Every once in a while you really get one right by way of timing.  Yesterday was one of those days.  I had no sooner written on Monday of the possibility of an alternative being found in the Yuan as an investment currency that the Chinese announced on Tuesday the relaxation of rules governing payments for Chinese exports allowing, by some estimates, up to 9% of exported goods to be settled in Yuan.  This is a further internationalization of the currency and just another step in a broading FX market whose timing seems to have accelerated in the past year.  Further liberalization coupled with a narrowing of a balance of trade surplus and a definite narrowing of China's balance of payments surplus points towards convertability goinig at an earlier date than I would bet most observers predicted...including yours truly.

I was feeling pretty good about this when comes the announcement that the Treasury was considering future issuance of debt that would bear floating rates.  Now just what is this about?

Floating rate notes have been around for quite some time in international markets, for 43 years to be exact. It's a simple concept, really.  Rather than issue debt that had a fixed interest rate, the indenture would contain the provision that the rate would be reset at some agreed-upon time frame--three months, six months, whatever really--based upon some agreed-upon base rate for example LIBOR as occured in the first instance.

1970 was the time of the Great Bank Invasion of London with American and Japanese Banks leading the way.  Eurodollar lending was exploding (by the way did you know it was essentially Moscow Narodny Bank that invented the concept of the "Eurodollar?  Now you do.) and there was a huge demand for secure dollar funding from non-dollar banks.  Enter the Floating Rate Note or, "FRN."  Initially for a term of but 2 to 3 years banks could issue substantial amounts of debt the rate on which would be set to a spread over LIBOR.  Reset every three months, the FRN would exactly match the profile of the issuer's loan book which, in those days (and still today) was based on a spread over LIBOR.  At the end of the day, a bank had secured funding on a moderately long term basis but took to interest rate mismatch against a loan book.  Billions of FRN's were issued and continue to be although far more funding mechanisms have emerged.

From a bank's standpoint there was another attractive feature as opposed to fixed rate instruments.  Given the reset of the coupon the notes always traded close to par assuming the same credit profile.  Needless to say if you expected a declining rate enviornment, you would try to maximize your funding through such instruments and visa versa.  It was a great idea.

The FRN, however, has never really caught on with issuers outside of the banking sector for obvious reasons, so when the U.S. Treasury begins hinting that this form of instrument may be in its borrowing future people like me begin to wonder why.  To be honest, I don't know.  The U.K. and a couple of other European countries have been doing this for some time but this would be a first for us.   Do we wish to shorten our maturity profile which now stands at 70 months indicating a belief for lower rates in the future?  Are we afraid of losing buyers to other markets and therefor are creating new product?  Are we concerned that without interest rate protection buyer will demand higer fixed rates in the future?  As I said I don't know but one thing is for certain; this is NOT your grandpa's Treasury market.  It is no time to make long term decisions with the bland assumption that all will be as it is and how it has been.  How does an economist build a building?  First, he assumes a foundation.  How do get "just a little more inflation?"  First you assume the continued availability of other people's money under the same terms as today.  Hey, that's what makes markets.

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