Flight to quality?

Since June, bond yields have fallen to the point where the U.S. government is getting paid to borrow money right across the entire yield curve. The 10-year is 3.8%, while inflation in the U.S. is 5.6% . What gives? This is either a flight to quality or a harbinger of hard economic times.

Caroline Baum asks the question we all want an answer to: are bond investors crazy or smart? I’ve got my money on smart, but she makes a pretty good argument for crazy too.

Are Bond Investors Crazy or Waiting to Exhale?: Caroline Baum

Inflation expectations are so weighted down that investors are buying 10-year Treasuries yielding 3.8 percent with inflation running at 5.6 percent.

Federal Reserve policy makers couldn’t ask for a stronger mooring in the face of disappointing inflation news. A pair of reports on consumer and producer prices for July showing year- over-year increases of 5.6 percent and 9.8 percent, respectively, the fastest pace in 17 and 27 years, failed to rattle the U.S. Treasury market.

There are two schools of thought on why Treasuries are expensive relative to inflation and an expected onslaught of supply to finance the growing federal deficit. The Bush administration projected a record $482 billion deficit in the fiscal year that begins Oct. 1.

The first holds that bonds are mispriced. Buyers are either complacent or smoking something stronger than tobacco. Even if they are in full command of their faculties, they are choosing liquidity over yield.

“Investors are willing to take a lower yield on risk-free investments” in light of questions about the solvency of Fannie Mae and Freddie Mac and systemic risks the Fed is working to mitigate, says Greg Ehlers, a managing partner at Navigate Advisors, a Stamford, Connecticut, brokerage firm.

The other school sees the market as forward-looking. Inflation may be elevated now, but bonds are telegraphing better (inflation) or worse (economic) news, depending on one’s reference point, ahead.

Great De-leveraging

Investors may be willing to accept a lower yield in exchange for assurances of timely payment of principal and interest. But why would they knowingly tie up money for 10 years in anticipation of a negative return when they have the option of investing for a shorter term or buying inflation-indexed bonds (TIPS), which offer a real yield plus compensation for actual inflation?

Answer: Because enough folks expect the great deleveraging under way, with its contractionary effect on money and credit, to pare inflation so that the return on a nominal 10-year note will exceed that on 10-year TIPS.

While I happen to think the bond markets sense an imminent fall in inflation, c’mon: a negative 1.8% real return on the ten-year is ridiculous. Given the gapping out of spreads on Fannie and Freddie, the talk of the GSEs needing $100 billion and the talk about Lehman Brothers selling out to anybody with available cash and having their credit lines pulled, it doesn’t take a genius to figure out fear is rampant in the markets.

Does it really matter? Both potential scenarios are dramatic to the extreme. Behind Door #1: you have a tapped out consumer, crashing the economy and taking inflation down with it. Behind Door #2: you have A major bank or Fannie and Freddie going belly up and needing a huge bailout. Pick a door.

Either way you look at it, we’re in for some turbulent times.

  1. MAB says


    Treasury yields are indeed puzzling. In my mind, the deflation expectation scenario doesn’t explain the sub 2% yields on the short end.

    I attribute the negative real yields to fear. Return OF capital is currently more important than return on capital. I still can’t get over the negative yield on the 5 year TIPS during the height of the Bear Stearns collapse. Talk about paying for insurance.

    The fed’s numerous panic moves over the past year tell the tale of the tape for me. Plus, at this stage, I don’t buy into the forward looking market mantra. We’re in unchartered and visibly dangerous waters – a place fear thrives.

    Does it really matter? Both potential scenarios are dramatic to the extreme

    Spot on. What else do you need to know?

    Oh yeah. Now I remember – panic first. And it is possible for almost everyone to panic first. Just like it’s possible for the majority to be above average investors.

  2. Edward Harrison says

    The risk spreads in the CDS market, in high yield, in sovereign debt, in GSE paper all suggests a major component of negative real yields for 10- and 30-year treasuries comes from fear and a flight to quality.

    The markets are in a bit of a panic, aren’t they? And the pros are just as bad as retail – worse even.

  3. MAB says


    Here's a thought that challenges the credit destruction view.

    The treasury now has the authority to backstop Fannie & Freddie. If the treasury limits losses to equity holders, where is the credit destruction?


Comments are closed.

This website uses cookies to improve your experience. We'll assume you're ok with this, but you can opt-out if you wish. Accept Read More