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|Interest Rate Outlook: Less than Zero?|
In the third quarter, U.S. gross domestic product was -0.5%, worse than the projected -0.3%, and unemployment levels continued to rise. As the margin calls roll in and the global deleveraging continues, investors and traders around the world are seeking a safe place to stem the bleeding and catch their breath: U.S. Treasuries. Demand has pushed bond prices to all-time highs, which of course has cut their yields to all-time lows.
"There's a lot of flight to quality based on fear in the market; that has been a key component of this. But at the same time, that drives interest rates. The lack of a return in the stock market ends up driving a lower return in interest rates in the long run," says Daniel E. Walsh, manager of Cydonia Capital. "Some of it is from liquidity problems, but people are also buying bonds on the speculation that stocks are not doing very well and are not going to do very well in the extended future."
The Nov. 18 Treasury International Capital Data report, which tracks international capital flows, showed that the net foreign purchases of U.S. long-term securities were $66.2 billion in September, a marked increase from August's $21 billion. But a deeper look at the report held several surprises. According to Treasury, China has now displaced Japan as the largest holder of U.S. Treasuries, with $585 billion in U.S. holdings, compared to Japan's $573 billion.
"This is a big deal. The Chinese continue to buy, so it allays the fear that they will dump [U.S. Treasuries] anytime soon, but it also means they have more bargaining power," says Ashraf Laidi, chief currency analyst for CMC Markets. Japan's consumption of U.S. debt peaked at $698 billion in August 2004, when the Bank of Japan was deliberately devaluing the Japanese yen.
"It is a sign of the times that the once-largest holder of U.S. Treasuries is retreating from Treasuries," Laidi says. "It suggests that the long-term value of the U.S. dollar is in play here." His other observation is that since 2005, U.S. stocks have been the only U.S. asset class that received a persistent net increase in foreign net purchases. Considering the beatdown U.S. equities have endured since October, that may not bode well for the future of equities, and the rally in Treasuries may just be getting started.
By all accounts, the trade in Treasury futures is much less liquid, a situation that has been made worse by the change to half-tick pricing, which has made the market even jumpier. As more traders and investors flee to the safety of Treasury bills, notes and bonds, driving up prices, their yields have fallen precipitously.
In early December, yields on 10-year notes fell to their lowest ever, 2.74%. "That's a huge drop in interest rates, at least for the 10-year note," observes David P. Floyd, president of Aspen Trading Group. "So that's a disconnect, the money supply has gone through the roof because of all the stimulus, but the bond market is not seeing that as inflationary," he adds.
Robert J. Griffin, independent bond broker and floor trader, says the 30-year bond yield could fall below 3.0% and stay there for a long time. "Guys on the floor ask, what does this mean? And we are slowly and inexorably heading to where Japan was 10 years ago: very small interest rates," accompanied by a spike in personal saving, malaise and deflation.
Even as they approach zero, the conventional wisdom is that U.S. interest rates will continue to decrease, much as Japan's did. However, many traders and economists say that a Japanese style deflationary cycle is unlikely because of the early and aggressive interventions by the Treasury department and the Federal Reserve Bank, which have allowed Treasury and the Fed to alter monetary policy and craft their many attempted bailout schemes.
Those rate cuts, interventions and quantitative easings have been much greater and earlier than anything the Bank of Japan attempted. "Liquidity injections are a form of reflation, which should work to counter deflationary forces," Laidi says, adding that battling deflation is Fed Chairman Bernanke's expertise. However, with the Fed's balance sheet expanding massively, the United States may remain in a prolonged state of disinflation.
The principal of a Treasury Inflation-Protected Security (TIPS) increases with inflation and decreases with deflation, as measured by the Consumer Price Index. On maturity, the owner is paid whichever is higher, the adjusted or original principal. Currently TIPS are projecting exceptionally low inflation, a point made by many who anticipate deflation in the United States.
However, Benn Steil, director of international economics at the Council on Foreign Relations, says this is merely a reflection of their lack of liquidity compared with short-term securities. "I don't think that means the market is predicting deflation or historically low inflation over the next 10 years. Everybody has flown to the most liquid instrument, which is short-term Treasuries."
Another argument against deflation in the United States is gold prices, which despite their volatility have held up well when compared with other commodities. A sharp spike in gold prices, on the other hand, would announce the arrival of inflationary fears, possibly resulting from the Fed's massive liquidity injections and Treasuries bailout schemes.
The TED spread is the difference between the three-month London Interbank Offer Rate (Libor) and the yield on three-month U.S. Treasury bills. The difference between the two interest rates, known as the spread, is generally considered the simplest way to gauge the market's sense of risk and the willingness of banks to loan money and grease the gears of capitalism. If the spread is widening, it indicates that the cost of capital is rising, reflecting more fear and a greater reticence for banks to loan money and therefore slower economic growth.
"Typically those rates are not more than 25 to 50 basis points different," Floyd says. "When we had this crisis in early October, that spread went to almost 4.6%," a measure of just how fearful banks were of lending to each other. The TED spread has since narrowed to 218 basis points in early December, but compared to its historical norm it remains elevated, which is one reason that equity markets have not stabilized, he says. Floyd expects the TED spread to continue narrowing and return to normal levels early in 2009.
The unknown is the Libor rate, which has fluctuated a great deal in the recent past. In early December, the Libor rate was 2.20%, a month prior it was 3.47% and 12 months prior it was 5.06%.
The yield curve, which describes the difference between short-term and long-term interest rates, is currently very steep, but interestingly both the short end of the curve, represented by three-month Treasury bills, and the long end, represented by 30-year Treasury bonds, are both in decline.
"The most surprising thing is that the 10-year and the 30-year are both trading at less than 4%. That's hard to fathom; it's not very bullish for our economy," Walsh says. "Yields under 4% in the 30-year imply a lack of growth for the next 29 years! The state of the 2009 economy isn't that rosy and the state of the 2039 economy isn't either!" he laughs (see "Where is the top?"). While the yield curve is very steep, Griffin says his concern is for the curve between Treasuries and corporate securities, which is even steeper and widening. "You have an environment where junk bond yields and yields on corporate bonds are extremely high relative to the Treasury bonds. Those are at record levels," indicating that money managers, money market funds and normal investors are not willing to put money into the commercial paper market, even for well-qualified, highly rated borrowers, thereby increasing the cost of capital and stifling growth. "We may end up in a unique situation where our Treasury yields are extremely tiny, but we still have these extremely expensive credit card interest rates, mortgage rates, junk bond yields, ordinary corporate bond yields; and it's going to be hard for the economy to recover from that," he says.
Having worked the short end of the yield curve so far down, Laidi says the Fed's next set of policy initiatives likely will attempt to bring 10-year yields down even farther by purchasing long-term securities from the Treasury. "Central banks do that when they are really desperate to bring down rates," he says. Otherwise the bond market could infer the expectation of a very prolonged recession, as long as three or four contractionary quarters.
While a steep yield curve can present difficult times for borrowers and lenders, a flattened or inverted yield curve would be worse, indicating deflation or persistent disinflation.
FEAR OF FAILURE
As more and more buyers pile into Treasury futures, five-year and 10-year notes are in ever tighter supply. "People are hoarding the bonds and are not willing to lend them out. It's a real issue," Griffin says. When a trader is short on delivery day, he is contractually obligated to deliver the note. If he cannot, he is obligated to deliver the next cheapest bond to cover it, which can be very costly and subject that seller to disciplinary action by the exchange. "If anybody gets short these bonds, they just fail, and the next guy fails; they are entwined in this Gordian knot," he says. All of which drives prices higher and yields lower.
Another issue is that with prices and yields at such extremes, shop-worn indicators are less and less useful and investors are more fearful.
The CBOT Fed funds futures had been a reliable guide for what the Federal Open Market Committee would do with interest rates, but no longer. "Right now it trades off the Fed effective," rather than the Fed funds rate, Walsh says. The Fed funds target rate right now is 1% and the Fed funds effective rate is 0.4%, leading him to believe rates will continue downward, possibly to zero.
"Lower yields should act as incentive for investors to develop a more healthy appetite for risk by the second quarter of 2009," says Carley Garner of Decarley Trading. That would stabilize equity markets, relieve consumer fears and encourage spending. The only question is when that will happen and what we endure until then.
"This has been a year of superlatives in the market: The biggest decline in the stock market ever, one of the most aggressive sets of rate cuts by a central bank ever, the highest increase in volatility ever, and this is making participants numb," Laidi says. "Lower interest rates are just another record- breaking landmark as we try to get a grip on the worst economic landscape since the Depression."