Wednesday, March 24, 2010

Treasury yield update

This is a follow-up to my previous post. Yields on T-bond have jumped about 15 bps in the past several days, in concert with the plunge in swap spreads (the 10-yr swap spread is now down to -9 bps, and has fallen 13 bps since last Friday). This adds weight to the argument that negative swap spreads reflect a decline in demand for Treasuries due to the perception of increased default risk.

I might add that since negative swap rates mean that high-quality corporate yields are now lower than Treasury yields of comparable maturity, this is consistent with the view that the outlook for the economy is improving (because corporate profits are strong and the market's estimate of corporate default risk is down).


Benjamin Cole said...

These very low yields might also suggest there is a glut of capital. Investors are storing liquid assets in any "safe" vehicle out there. After a while, who notices the diff of a few basis points? You are parking money, awaiting a market signal to buy something.
In less gloomy momemts, I have to say this augurs well for equity and property investors, if the general investor mood ever improves.
We may yet see another couple years of corporations borrowing (cheaply I might add) and building enterprises, rather than issuing stock.
So, maybe if our luck is right, we see an equities boom out there somewhere. It would help if investors had confidence that our financial system is not a house of cards.

John said...

In the early to mid 1990s bank stocks had a tremendous rally coming out of a bad recession caused in part by real estate excesses. I did well in those years but could have done better had I a clearer understanding of what was happening. The Federal Reserve was re-liquifying the bank balance sheets decimated by bad real estate loans by holding short term interest rates low for an extended period of time. The banks recovered and eventually began making profitable loans again in a normal economy. It is my opinion that now, nearly twenty years later we are in a similar situation. Treasury bond yields are beginning to climb signaling a better economy. Bank bond yields are falling signaling less anxiety about bank solvency. Quality high yield is scarce and yield investors are hungry. The leap to equity yield is not a large one for some investors. For me the signals are there. I've seen this dance before.

Benjamin Cole said...

I think there is much merit to what you say.
I see the same 20 year cycle in CA real estate. There is a boom, then a lengthening boom as all parties dream up reasons why prices are justified. Barriers to develop, not making land anymore near the coast, its an international market blah, blah, blah.
Lenders lend on anything, even if the loan pencils out only if a building is re-habbed and gets higher rents.
Then the market busts, and gets gets cut in half. The Fed and feds rescue everybody (this is commercial property we are taking about), and bottomdwellers start to buy, and the cycle starts up again.
Probaly 10 years from SoCal real estate will heat up, and then another protracted boom will begin.
I hope sooner, but you never know.

Benjamin Cole said...

I have posted here a few times that SoCal commercial real estate has been cut in half. Maybe I should have said "one-quarter."

"A foreclosed Beverly Hills parcel (40,000 sf of land) slated for the development of a luxury condominium and retail complex is expected to command less than one-quarter of the price that it traded for two years ago.

Los Angeles developer Hagop Sargisian acquired the site at 9200Wilshire Boulevard in 2008 for $54 million. It financed the acquisition with $52 million of loans - a $31 million senior loan from troubled Broadway Bank of Chicago and a $21 million junior loan from Connaught Real Estate Finance, a Chicago fund shop headed by a Broadway director, Sean Conlon."

Commercial real estate is a relatively free market, not artificially juiced by federal agencies such as Fannie or Fredie.

Yet the collapse is epic. This suggest to me that free markets bust, ala Tulip Bulbs, dot.coms, and various real estate plunges.

With the advent of greater leverage in our banking and financial systems, these periodic free market busts become magnified and even catastrophic.

We need soe sort of firewalls in our financial system to assure it does not tumble like a house of cards in response to the next bust.

Scott Grannis said...

Business cycles happen with seeming regularity, but this doesn't mean that the financial system is inherently flawed or that there is a house of cards waiting to collapse at every turn. I believe that every boom and bust can be traced to mistakes in fiscal and monetary policy. That is where you need to look for the next bust.

Scott Grannis said...

John: I agree

Jay Norman Davis said...


there is alot I do not understand,but,a couple of questions. First, could there be a flight from treasuries because people want a return on their cash, not because a possible default. secondly, if the treauries default could anything have value, corps. banks without FDIC,etc. Also where is a person to invest cash that they do not wish to speculate with. Thank you, Jay

Scott Grannis said...

If there is indeed a "flight from Treasuries" then it means that people feel more comfortable about the return on their investment if they buy corporate bonds instead of Treasuries. It means that the market is more willing to buy a 10-yr bond from XYZ Corp. with a 3.7% yields than it is to buy a 10-yr T-bond with a 3.8% yield. A rational person would do that only if he perceived greater default risk in the Treasury bond (all other things being equal).

It is certainly possible, at least in theory, for the U.S. Treasury to default on its obligations, without that affecting the ability of corporations to pay their debts. There are many such instances in the history of emerging market debt (the sovereign issuer defaults, but the corporate bonds keep paying)

I've argued many times in the past that the best place to put cash that you don't want to lose is in TIPS, since they protect you from default and from inflation. If you don't trust the US government however, then your next best bet is short-term debt of highly rated, strong companies.

Jay Norman Davis said...


Thank you for that explanation, but how do tips differ from T bills regarding default.

Scott Grannis said...

Both TIPS and bills are official Treasury debt, so default risk is theoretically the same. The US government stands behind both equally. TIPS are adjusted for inflation, bills are not.

Gary said...

Scott -- negative swap spreads seem a rather straight forward flight to quality (and away from US Treasuries).

Yes, college professors have been indoctrinating students into believing that US Treasury = risk free via CAPM models and such, but anyone who studies history knows better

The more the US acts like Greece or a banana republic, the more the smart money (and apparently supermodel Giselle?) will treat the US like a banana republic.

I am embarrassed at the number of stupid fellow Americans who believe ObamaCare will be "free". How many times do supposed adults have to be swindled with the "free lunch" scam?

Giselle isn't fooled (and note she made her comment about the US some years ago) -- and she wasn't the first (or the last) to question the US government's credit worthiness.

But when supposedly intelligent people hear that the government is already in debt (on balance sheet) 90% of GDP AND it plans to run 10% of GDP deficits for at least the next 10 years...

and then the leader of this banana plantation openly bribes congress to implement even more spending?

Then a Nobel Prize winning elitist (Krugman) comes out and tells our creditors (the Chinese) to go f&*_ themselves?

There is no free lunch. Never was, never will be. Someone is going to pay for this spending spree.

Treasury buyers are just saying that if we are going to act like a banana republic, we will have to pay banana republic rates.

In most banana republics, stable corporations pay lower rates than the host government. No matter how messed up things got in Brazil or Chile -- Vale and PCU always had access to funds, and always at a better rate.

Obama acts like a banana republic dictator, Krugman tells our creditors to pound sand, and Mr/Mrs America say they are entitled to a free lunch because they voted for it

Who would lend money to that?

Scott Grannis said...

Gary: indeed, we live in very interesting times.

Paul said...

Sorta related: Iraq's debt almost on par with California.