Introduction

The debt of the US Government can be divided into two categories namely marketable and non marketable.  US Treasury bills, notes and bonds represent the marketable government securities.  Since these debt obligations are backed by the “full faith credit” [1] of the US Government and are considered the safest of all investments.  These are viewed as zero risk investments and ensure that the principal and the interest will be paid on time.  Due to the high perceived safety of this investment the interest offered by the US Treasuries is lower than other debt instruments such as the corporate bonds. The interest on the US Treasury bonds are exempt from state as well as local taxes as well.

Monetary Policy

  This is the mechanism by which the Central Bank controls the liquidity in the market.  One of the operations is called the Open Market Operations essentially involving the buying and selling of the Government issued T-bills. Buying T-bills aims to increase the liquidity in the market which leads to lower interest rates. The reverse is true when T-bills are sold.  When there is excess money in the markets the T-bills are sold which reduces the demand for T-bills and increases the interest rates to curb borrowings.

Fiscal Policy

The Fiscal Policy deals with the budget of the United States.  This refers to the attempts of macro-economic changes in the US by means of taxes or some fiscal allowances.  While the monetary policy controls the interest rates the fiscal policy determines the government spending and taxation.  A fiscal deficit may be funded by issuing treasury bonds.  Growing public debts and persistent deficits is expected to increase inflationary pressures which would cause the central banks to increase the short-term interest rates.  Expectations of these pressures cause an increase in the long term interest rates by the financial institutions[2].

Inflation

 Inflation tends to shrink the purchasing power of the principal unless it is factored in the expected yield.  For Example, if the inflation rate is 18% and the yield on a T-bill is 0.35% then in terms of the actual buying power the value of the T-bill actually dropped by over 17%. This picture does not change much over longer periods. So, while T-bills may be a sound technique for preserving capital, historically they have fallen short as growth investments and have barely outstripped inflation.[3]

Real Interest Rates

The Real Interest rates refer to the inflation adjusted yield that the T-bill will pay at maturity.

BOP

The Balance of Payments represents the trade and financial transactions between the residents of one country with the residents of another country.  These include import export transactions and all other international trade and commitments of the US with other countries.  Inequalities in these transactions  cause a surplus of deficit in either services, goods or foreign investment income.  A country with a deficit in the current account of the balance of payments implies a higher gross national product and higher interest rates.[4]

GDP Growth:

The US economy is the largest economy in the world. The GDP measures the purchasing power of the economy. The following chart represents the Annual GDP growth adjusted by inflation [5].

Several economic indicators imply that the economy is likely to deteriorate further. High GDP growth implies that the standard of living is high.  A shrinking economy leads to reduction of the interest rates to enable the circulation of more money in the economy.

3 Month Treasury Bills:
These are extremely liquid and they mature in 3 months duration.  These are not traded in secondary markets.  These are issued through a competitive bidding process below par ensuring a higher yield to maturity.

When the bond investors do not expect downward trends in the economy then the yield curve slopes upward indicating investors who invest their money for longer periods of time get better yields.

The above chart shows the actual and the forecast of the 3 month US T-bill[6].

The following chart [7]shows the performance of the real interest rates of 3 month T-bills  over the past few years.  This implies an economy with mixed signals and the yield being a flat to an inverted curve at this time. Going long under the circumstances indicates high uncertainty and possibly negative returns. So going long on TIPS or the inflation adjusted T-bills is a possibility.

1 Year Treasury Bill

The above chart [8] show the trend of the declining yields on the 1 year US T-bill.  Given the expected inflationary pressures it is advisable to go short on the 1 year treasury bill.

10 Year Treasury Note
The fluctuation of the interest rate on the 10 year treasury provides information about the probable future changes in the interest sensitive sectors of the economy.[9] For example the mortgage rates are correlated with the movements of the 10 year treasury rate and the changes in the mortgage rates precede changes in the housing markets.

[10]

Given the inflation adjusted forecast in the above chart it is advisable to go long on the 10 year T-Notes.

References

Stein, Herbert, Balance of Payments, Referenced on February 22, 2009, http://www.econlib.org/library/Enc/BalanceofPayments.html

Daily Treasury Yield Curve Rates, referenced on February 21, 2009, http://www.ustreas.gov/offices/domestic-finance/debt-management/interest-rate/yield.shtml

Financial Forecast Center, Referenced on February 22, 2009, http://www.forecasts.org/1yrT.htm

Fiscal Policy and Interest Rates, 2005-2008, Referenced on February 22, 2009, http://www.ofce.sciences-po.fr/pdf/dtravail/WP2005-08.pdf

[1] Treasury Bonds, http://www.bestcashcow.com/cash_equivalents/tbonds.html
[2] Fiscal Policy and Interest Rates, http://www.ofce.sciences-po.fr/pdf/dtravail/WP2005-08.pdf
[3] Inflation and Return, http://www.pathtoinvesting.org/experts/manage_indexavg/manage_041.htm
[4] Stein, Herbert, Balance of Payments
[5] Trading Economics, http://www.tradingeconomics.com/Economics/GDP-Growth.aspx?Symbol=USD
[6] Financial Forecast Center, http://www.forecasts.org/3mT.htm
[7] Real Interest yields , Market Oracle, http://www.marketoracle.co.uk/Article2797.html
[8] Financial Forecast Center, http://www.forecasts.org/1yrT.htm
[9] Economic Indicators, http://www.newyorkfed.org/education/bythe.html#10yrt
[10] Financial Forecast Center, http://www.forecasts.org/10yrT.htm