Party like it’s 1993?
Bills Yielding Zero as Stocks Soar Make Bernanke’s 1938 Moment
By Liz Capo McCormick and Daniel Kruger
Nov. 23 (Bloomberg) — For the first time in seven decades, Treasury bills are paying no interest while stocks continue to appreciate — a divergence in U.S. financial markets that might be perilous if Federal Reserve Chairman Ben S. Bernanke didn’t know all about 1938.
That’s when the Standard & Poor’s 500 Index climbed 25 percent even as bill rates tumbled to 0.05 percent from 0.45 percent. As 1939 began, stocks began a three-year, 34 percent decline after the Fed increase borrowing costs prematurely to stymie inflation that never materialized.
While almost no one expects Bernanke, a self-described “Great Depression” buff, to raise rates before mid-2010, bond investors say with unemployment above 10 percent and housing taking another downturn, they have no qualms about lending the government money for nothing to ensure their capital is preserved. Stock investors, meanwhile, say the worst is over and that low borrowing costs coupled with the $12 trillion of fiscal and monetary stimulus will bolster earnings.
“The question is what are you going to do with all the money that has been created?” said James Hamilton, a former visiting scholar at the Fed who teaches at the University of California, San Diego. “It’s not a contradiction at all to see very low short-term yields and at the same time have people trying to buy stocks. They are both reflecting that same force.”
Dipping Below Zero
Three-month bill rates closed at 0.005 percent last week, down from 0.11 percent at the end of September and the year’s high of 0.34 percent in February. Traders said the rate dipped below zero on some bills due in January on Nov. 19.
As money poured into bills, the S&P 500 ended little changed on the week at 1,0931.38, up 64 percent from the low this year of 666.79 on March 6. The S&P GSCI Index of 24 commodities rose 46 percent this year, rebounding from last year’s 43 percent slump. Investors in high-yield, high-risk, or junk, corporate bonds earned a record 52 percent this year, according to Merrill Lynch & Co. indexes.
“A lot of these markets have been driven by excess liquidity and are not necessarily supported by economic fundamentals,” said Thomas Girard, a managing director at New York Life Investment Management who helps oversee $115 billion in fixed-income assets. “Clearly there is a class of investors that are nervous,” said Girard, who is avoiding bills and instead buying high-rated corporate bonds.
Bernanke, who has been studying the causes of the Depression since he was a graduate student at Massachusetts Institute of Technology, said on Nov. 16 that it’s “not obvious” that asset prices in the U.S. are out of line with underlying values. He didn’t address asset prices outside of the country. In 1989, he wrote an article with Mark Gertler, a New York University economics professor, for the American Economic Review in which they presented a detailed model that helps to explain the cascade of events that led to the collapse of markets in the years after the 1929 crash.
“It is inherently extraordinarily difficult to know whether an asset’s price is in line with its fundamental value,” Bernanke said in response to audience questions after a speech in New York. “It’s not obvious to me in any case that there’s any large misalignments currently in the U.S. financial system.”
Equity investors say they have history on their side. The S&P 500 rose an average 8.4 percent in the six months before the last five increases in the Fed’s target rate for overnight loans between banks and added another 82 percent in the bull markets that followed, according to data compiled by Bloomberg. Shares typically rise before central banks push up interest rates because markets anticipate economic expansion first.
‘Enough of It’
The median estimate of 60 economists surveyed by Bloomberg News is for policy makers to keep their target rate for overnight loans between banks in a range of zero to 0.25 percent until the third quarter of 2010.
“There’s clearly room for the stock market to do better,” said Mark Bronzo, a money manager in Irvington, New York, at Security Global Investors, which oversees $21 billion. “If money is all going into short-term securities, at some point, investors will say ‘enough of it’ and the next incremental change will be for money to chase riskier assets.”
The bulls got a boost last week when the Organization for Economic Cooperation and Development doubled its growth forecast for the leading developed economies next year as China powers a global recovery. The economy of the group’s 30 countries will expand 1.9 percent in 2010, the Paris-based organization said in a Nov. 19 report, up from a prediction of 0.7 percent in June.
‘Recovery in Motion’
“We now have numbers that support a recovery in motion,” Jorgen Elmeskov, the OECD’s acting chief economist, said.
Demand for bills has also been driven by banks adding the safest securities to improve balance sheets at year-end, a drop in sales as the Treasury lessens its dependence on short-term financing and fewer alternatives as companies cut back on sales of commercial paper.
“I don’t see negative yields in this current environment as anything anomalous,” said Joseph Mason, a banking professor at Louisiana State University in Baton Rouge and former economist at the Office of the Comptroller of the Currency.
Even so, bond investors doubt the strength of the recovery after the Federal Housing Administration said last week that foreclosures on prime mortgages and home loans insured by the agency rose to three-decade highs in the third quarter. Builders broke ground on 529,000 houses at an annual pace in October, down 11 percent from September and the fewest since April’s record low, Commerce Department figures showed Nov. 18.
“Everything is not dandy in this world,” said Axel Merk, who manages more than $550 million as president of Palo Alto, California-based Merk Investments LLC and has been buying bills. “Sure money is flowing into risky assets and people are leveraging up, but it is only available to those with pristine credit. It is still a very difficult environment for people to function in and many would still rather hold Treasuries.”
In Treasury auctions during the week ended Nov. 6, the combined bids for the $86 billion in one-, three- and six-month bills sold was a record $361 billion, $100 billion more than the peak set during the height of the credit crisis last year, according to Jim Bianco, president of Bianco Research in Chicago.
The bid-to-cover ratio for the three-month bill auction reached 4.29 in September, the highest since 1998. The ratio has averaged 3.9 since September, up from 2.74 in 2008. When the U.S. sold $32 billion of four-week bills Nov. 16, the figure was 3.79.
“We cannot spin a positive story from the fact that a third-of-a-trillion dollars a week is trying to lock down Treasury bill yields of less that 0.05 percent,” said Bianco. “There is still tremendous demand for the front end of the curve despite the fact that people are saying things like there is no yield there and that cash is trash.”
Yields on government bonds are falling, too, with the average dropping to 2.20 percent last week from 2.50 percent in August, according to the Merrill Lynch Global Sovereign Broad Market Plus Index.
Finance officials in Japan and China, Asia’s two largest economies, said last week that the Fed’s monetary policy risks spurring speculative capital that may inflate asset prices and derail the global economic recovery. The central bank’s target rate has been between 0 and 0.25 percent since December.
‘Process of Reflation’
Bill Gross, who runs the world’s biggest bond fund at Newport Beach, California-based Pacific Investment Management Co., said that the “systemic risk” of new asset bubbles is rising with the Fed keeping rates at record lows.
“The Fed is trying to reflate the U.S. economy,” Gross said in his December investment outlook on Nov. 19. “The process of reflation involves lowering short-term rates to such a painful level that investors are forced or enticed to term out their short-term cash into higher-risk bonds or stocks.”
Economic growth will be unlike most post-recession periods with banks reluctant to lend, the personal savings rate lower, the labor market less cyclical, excess housing supply greater and state and local budget gaps larger, according to Jan Hatzius, chief U.S. economist at Goldman Sachs Group Inc. in New York. His forecast of 2.1 percent growth in 2010 is below the 2.6 percent median of 63 economists surveyed by Bloomberg News.
The flight into bills may mean that yields on shorter- maturity debt hold at about record lows into 2010 as longer-term yields rise. The so-called yield curve that measures the gap in rates between 2- and 10-year Treasury notes expanded to 2.66 percentage points this month, the widest since July.
That benefits Citigroup Inc., JPMorgan Chase & Co. and banks which have taken $1.7 trillion in writedowns and losses since the start of 2007 and which make money on the difference between the rates they pay on short-term deposits and the interest income generated on loans.
“A lot of people have been hiding out in the front end of the curve, waiting to see how this economy turns out,” said Christopher Bury, co-head of fixed-income rates in New York at Jefferies & Co., one of the 18 primary dealers that trade with the Fed and are required to bid at Treasury auctions. “As a short-term parking mechanism, Treasury bills provide great liquidity and safety.”
The allure of bills increased last quarter after the government dropped its guarantee of money market mutual funds, said Merk, who is now only putting his fund’s dollar-denominated cash in bills. The Treasury’s guaranteed money market mutual fund deposits a year ago to stem an investor run the week after Lehman Brothers Holdings Inc.’s bankruptcy led to the collapse of the $62.5 billion Reserve Primary Fund, triggering a run on assets. The guarantee expired Sept. 18.
The supply of bills will decline about 10 percent from September through February as the Treasury cuts its Supplementary Financing Program for the Fed to $15 billion from $200 billion, said Louis Crandall, chief economist of Wrightson ICAP in Jersey City, New Jersey. When the Treasury sells bills at the Fed’s behest, it drains reserves from the banking system and makes the central bank’s job of controlling rates easier.
“Bill yields can stay down here for a considerable period,” said Robert Auwaerter, head of fixed income at Valley Forge, Pennsylvania-based Vanguard Group Inc., which manages $1 trillion in assets. “There’s still a demand for high-quality assets at the front end of the curve, and a lack of alternatives.”
Commercial Paper Contraction
Unsecured commercial paper outstanding was $1.24 trillion in the week ended Nov. 11. While that is up from a seasonally adjusted $1.07 trillion in July, it’s below the $2.22 trillion reached in July 2007, before the collapse of the subprime mortgage market.
Demand for bills typically rises at year-end as banks buy more to bolster their balance sheets at year-end, said Thomas L. di Galoma, head of U.S. rates trading at Guggenheim Securities, a New-York based brokerage for institutional investors.
Fed officials are stepping up scrutiny of the biggest U.S. banks to ensure the lenders can withstand a reversal of soaring global-asset prices, people with knowledge of the matter said last week. Supervisors are examining whether banks such as JPMorgan, Morgan Stanley and Goldman have enough capital for the risks they take, how much they know about the strength of their counterparties.
“At some point reality is going to bite us in the backside,” said Michael Cheah, who manages $2 billion in bonds at SunAmerica Asset Management in Jersey City, New Jersey. “We are living in the best of times and the worst of times. Unfortunately the best of times cannot continue celebrating like this when the economic fundamentals are worsening rapidly.”