In Bloomberg last week, I argued that the price of safety is mis-priced. Real yields have been negative for the better part of the last 10 years, and have been very negative since the pandemic. And the Fed has no plans to bring it above zero. I can understand a market negative real yield from time to time for convenience reasons. But all of the time? For decades? How can you explain that? Well, I blame the Fed and regulatory policy, as well as other countries buying lots of safe assets to manage their currencies. Lately, it’s been a lot of the Fed.
The risk-free rate is always being tinkered with by policymakers. Maybe it never actually equals the market price, but sometimes it’s more distorted than others, and it seems like it’s really off right now. And if that’s true, what does that say about the price of any risky asset? Perhaps that explains why crypto currencies are worth so much despite not offering much inherent value and having such a high Beta. When celebrities are hawking an esoteric risky asset, you know something is wrong.
Risk-free assets are the most systematically important asset in markets. They touch absolutely everything. And when it goes wrong, things get real. When market prices are not market prices for years at a time, risk gets distorted, and people subsequently take on more risk than they realize. I’m not predicting a financial crisis, but I do reckon that this could be why markets are just so weird right now.
Even with exceptionally low interest rates, the federal government is projected to spend just over $300 billion on net interest payments in fiscal year 2021. This amount is more than it will spend on food stamps and Social Security Disability Insurance combined. It is nearly twice what the federal government will spend on transportation infrastructure, over four times as much as it will spend on K-12 education, almost four times what it will spend on housing, and over eight times what it will spend on science, space, and technology.
Publication Date: 10 Mar 2021
Publication Site: Committee for a Responsible Federal Budget
The core of the problem is that as inflation soared, bond yields fell, creating an instant contradiction: Inflation is poison to bond investors, so they would normally be expected to sell. I have an explanation, but it isn’t perfect.
My take: Investors came to the realization that the huge post-pandemic debt burden will keep rates lower than in the past, while they kept faith that inflation will be manageable. There is little to indicate investors fear a recession-inducing mistake by the Federal Reserve, and they aren’t expecting runaway inflation either.
The market response from March to the start of this month can be thought of as pricing in a repeat of the secular stagnation brought on by the 2008 financial crisis, with the twist of slightly higher inflation than in the past decade.
And there is one more oddity that is far harder to understand: By Aug. 3, yields on 10-year Treasury inflation-protected securities, or TIPS, reached minus 1.2%, the lowest point for inflation-adjusted yields in history.
It could only make sense if investors were expecting stagflation, or weak economic growth combined with higher inflation. But if the risk of stagflation were rising, investors should be buying gold — which usually rises when TIPS yields fall — and dumping the junkiest corporate bonds, as defaults would be sure to rise. Instead, the relationship between gold and TIPS broke down, while junk bond yields rose only a little from what had been close to record low spreads over Treasurys.
Second, there is another $12 trillion in dollar-denominated assets issued by entities outside the United States, according to the Bank for International Settlements. Combine this with the dollar assets exported from the United States, and there exists roughly $32 trillion in relatively liquid and safe dollar assets abroad, as seen in the figure below.
There is no other currency system that comes close to providing so many safe and liquid assets to the world. On one hand, this outcome is not surprising, given the dollar’s dominant role in the global economy. On the other hand, the implication of this fact is astonishing: There is no alternative source of safe and liquid assets available on such a large scale. This means that if investors wanted to break up with the global dollar system, there would be nowhere else to go to meet all their relationship needs.
Expectations of a stronger economy count as a positive development for companies’ earnings prospects, but they are pushing long-term interest rates higher, with the 10-year Treasury recently yielding 1.41% versus 0.93% at the start of the year. That isn’t unusual, since long-term rates typically go up as the economy’s prospects improve, but then again stocks haven’t tended to be as expensive at the start of recoveries as they are now.
The S&P 500 trades at about 22 times analysts’ expected earnings over the next year, according to FactSet, which is close to its highest forward price-earnings ratio in 20 years. In December 2009, six months after the last recession ended, the S&Ps forward P/E ratio was about 14.
As a result, even relatively modest moves upward in Treasury yields, and therefore the relative attractiveness of bonds to stocks, can cause market spasms. This is particularly true of the richly valued technology shares that have been among the biggest market winners since last spring.
Yields on most U.S. government bonds fell Monday, showing further signs of stabilizing after soaring to multi-month highs last week.
The yield on the benchmark 10-year Treasury note settled at 1.444%, according to Tradeweb, down from 1.459% Friday.
Shorter-dated yields also headed lower, in a reversal from last week when investors bet that the Federal Reserve will start raising interest rates earlier than previously anticipated in response to an expected burst of economic growth and inflation.
The five-year yield settled at 0.708%, from 0.775% Friday. Yields fall when bond prices rise.
A wave of selling during the past two weeks drove the yield on the benchmark 10-year Treasury note, which helps set borrowing costs on everything from corporate debt to mortgages, to above 1.5%, its highest level since the pandemic began and up from 0.7% in October.
Traders said concerning dynamics were evident in a Treasury auction late last week. Demand for five- and seven-year Treasurys was weak Thursday heading into a $62 billion auction of seven-year notes and nearly evaporated in the minutes following the auction, which was one of the most poorly received that analysts could remember.
The seven-year note was sold at a 1.195% yield, or 0.043 percentage point higher than traders had expected — a record gap for a seven-year note auction, according to Jefferies LLC analysts. Primary dealers, large financial firms that can trade directly with the Fed and are required to bid at auctions, were left with about 40% of the new notes, about twice the recent average.
The sharp increase this month in U.S. government-bond yields is pressuring the stock market and forcing investors to more seriously confront the implications of rising interest rates.
The lift in yields largely reflects investor expectations of a strong economic recovery. However, the collateral damage could include higher borrowing costs for businesses, more options for investors who had seen few alternatives to stocks and less favorable valuation models for some hot technology shares, investors and analysts said.
As of Friday [Feb 19], the yield on the benchmark 10-year U.S. Treasury note stood at 1.344%, up from 1.157% just five trading sessions earlier and roughly 0.9% at the start of the year.
Earlier this year, the $3.9 trillion market where states, cities, schools and other issuers sell debt had been resisting a steep sell off in Treasuries that lifted yields, putting the historically close correlation between the two markets out of whack.
Now, munis are catching up, with the 10-year yield on Municipal Market Data’s (MMD) benchmark triple-A scale, which started 2021 at 0.720%, climbing 45 basis points since Feb. 12. It closed up 5 basis points at 1.14% on Thursday.
The iShares National Municipal Bond exchange-traded fund (ETF) fell on Thursday to its lowest level since November at 115.14. The largest muni ETF, which reached an 11-month high of 117.95 on Feb. 11, was last down 0.43% at 115.30.
A flood of money pouring in? Check: Muni bond funds added about $2 billion in the week ended Feb. 17, according to Refinitiv Lipper US Fund Flows data, building upon a $2.6 billion inflow in the prior period that was the fourth-largest on record. Scarce supply? You bet: Some analysts estimate that states and cities in 2021 will bring to market the smallest amount of tax-exempt bonds in 21 years. Fiscal stimulus supporting its case? Indeed: The prospect of $350 billion in aid to state and local governments should help stave off any widespread credit stress.
Perhaps most remarkably, though, muni investors appear to have fully embraced the “HODL” mentality of the crypto crowd. In typical times, February’s sharp selloff in U.S. Treasuries, which has sent the benchmark 10-year yield up almost 30 basis points to 1.35% (for a monthly loss of almost 2%), would have reverberated by now across the market for state and local bonds. Instead, tax-exempt yields have been borderline immovable; they only finally started to budge toward the end of last week.
By that time, municipal bonds became arguably the most expensive asset class anywhere. As Bloomberg News’s Danielle Moran noted, yields had fallen so low on top-rated tax-free debt that even after accounting for the exemption from federal taxes, it still made more sense for investors to purchase Treasuries instead. It’s certainly fair to argue that Bitcoin isn’t worth more than $50,000, or that shares of Tesla Inc. shouldn’t be trading at more than 1,000 times earnings. But it’s at least possible to make the case that they should. It’s not every day that a corner of the bond market rallies to such an extent that it’s objectively a bad deal.