Tuesday, January 6, 2009

The price of safety is falling -- excellent news

I think this is one of the most important developments in recent days—T-bill yields are rising. 3-mo. T-bills are the world's risk-free asset. Until recently, their yield had fallen to zero (and was briefly negative). Bill yields are now rising. They are still miniscule, but they are clearly rising. I'd say this chart is the best picture you'll find of the state of the economy, which is most likely in a slow bottoming process.

T-bills represent the very front end of the Treasury yield curve, and are the preferred habitat of all those who demand absolute (such as the world ruled by men can provide) safety. Rising bill yields will thus reflect reduced demands for safety and growing confidence that the economy and the financial markets are on the mend and not on the skids.

Rising Treasury yields will occur in lockstep with improvements in the economy. Treasury yields are currently priced to the expectation that the economy will be extremely weak for an extended period; that inflation will likely be negative for at least the next 5 years; and that because of anemic growth and deflation the Fed will keep policy extremely accommodative for at least the balance of this year, and not raise short-term interest rates meaningfully until sometime in 2010. Therefore any tendency for the economy to pick up and/or deflation pressures to subside will automatically result in expectations for an earlier monetary tightening from the Fed and thus higher Treasury yields across the board.

I would agree with those who say that Treasury yields are in "bubble territory." They are priced to the assumption that the economy has very little chance of a meaningful recovery for as far as the eye can see, and that inflation will remain extremely low for a very long time. Those are very risky assumptions in my view.

6 comments:

SpeakToMe said...

I agree with you. One interesting anomaly -- there are a lot of intelligent, heretofore successful people here in the NY area that are offended by the idea that the financial meltdown is over. They get upset if you don't agree that its only just begun, and that the worst is yet to hit the country.

I think that may be true for home prices, which I believe are only half way through their correction. I don't think its true for the financial markets.

Your perch in Calafia Beach may help you be more objective -- that's my assumption. Similarly, I spend most of my time on the Internet, which has been relatively impervious to this slowdown. The NY financial markets are more ground zero.

Scott Grannis said...

I've always thought that being on the West Coast and far from the streets of Manhattan gave one a certain objectivity.

Brian said...

Question - With T-bills ticking up - do mortgage rates stop their slide now, or could they still head down some more?

Brian said...

...and you guessed it - I'm waiting to lock but now a little unsure...

Scott Grannis said...

Brian: Mortgage rates are ultimately determined by the 10-year Treasury yield. Right now mortgage rates are still a bit high relative to the 10-year. If the 10-yr holds current levels, mortgage rates could decline a bit more. They won't go up significantly until it becomes clear that the economy is improving. Keep your eye on the 10-yr for guidance.

Brian said...

Gracias...