Thursday, November 19, 2009

Bill yields return to zero

Yields on 3-mo. T-bills have gone to zero, once again. The last time this happened was in December of last year. At that time, the world was in full panic mode, with markets braced for a double-deep depression and years of deflation. The stock market was about 20% lower than it is today, credit and swap spreads were on the moon, the Vix index was almost double what it is today, and 10-yr Treasury yields were approaching 2%.

So now that the signs of panic have receded hugely, why are bill yields again approaching zero? It could be year-end pressures, as portfolio managers unwind risky positions and build up cash so their year-end statements reflect some prudence. Or it could be that, as I've mentioned in recent posts on TIPS, the market is capitulating to the idea that the Fed is going to keep the funds rate near zero all throughout the coming year. Alternatively, it could be that the prospect of the Fed being on hold for a prolonged period is awakening inflation expectations; if you're a bond manager afraid that bond yields may be rising in the future, you'll want to sell bonds and park the money in cash and TIPS. The facts seem to support this last explanation best, since the yield curve is unusually steep and breakeven inflation expectations have risen meaningfully as bill yields have collapsed.

So I'm tempted to say that the best explanation for why bills are trading near zero is that the bond market is feeling very uncomfortable with the idea of one more year of zero rates from the Fed. I sympathize with that feeling, since I find it very hard to believe that the Fed will actually deliver on its promise to keep rates at zero for a very long time. I see too many positive developments in the economy on the margin, and I see too many signs of rising inflation pressures on the margin. I think the Fed could and should raise rates much sooner than most people suspect.

In any event, bill yields approaching zero are one way the market has of telling you to watch out for surprises that could be lurking behind the next corner.


Jeff said...

Just so I'm clear...based upon you are seeing/believing, what is your recommendation going forward? More Risk assets (i.e. stocks), TIPS and hard assets (i.e. gold, real estate, etc.)?

Thanks for your input.


ronrasch said...

Jeff, I am not Scott who has provided us with world class analysis. I suspect that if interest rates rise, the whiffs of inflation Scott detects will become full scents to the markets of inflation and that stocks will take a hit. I am sure that the size of rate increase will be key and that is why we will be reading Scott

Scott Grannis said...

To not buy risk assets you have to be basically terrified of the economy. I think there is still plenty of room for risk assets to improve. I don't see the economy collapsing or suffering from even a mild recession.

Further, though the markets would probably take a hit when the Fed does tighten, I think it would only be temporary. I think at this point a Fed tightening actually would be a very welcome thing. One of the reasons bill yields are at zero is that the bond market is getting very nervous about what the Fed is doing. Playing with inflation fire is not a good thing. Acting responsibly would be a good thing.

mojakus said...

My money markets desk is saying the zero-yields in t-bills are partly the result of short-term cash funds/MMFs hoarding cash until just a few weeks ago. Now that they realize there's no liquidity crunch at year-end (much the oposite in fact) they've started to put money to work "over the turn".

Why in bills? it's not panic, just relative value: at the margin, they'd rather earn 0% on bills than 0.08% on ABCP or CDs. Why not leave cash sitting at the custodian? If they do, they'll get charged deply negative rates by their clearing banks. There's a lot of liquidity sloshing around the short-end.