It had to come to this sooner or later. Interest rates broke zero at an auction of 5-year Treasury Inflation-Protected Securities last week. The auction lead to a nominal negative 56 basis points coupon for the notes, so evidently folks are convinced enough to pay 102 for a bond that will return 100 in five years, with only the inflation adjustment to change that outcome.
The last time the Feds got away without having to pay interest was during the Great Depression when T-bills yielded minus 12 basis points during the hysteria around the bank holiday in 1933. So much for the zero bound on interest rates.
The government has been flooding the market with bond issues over the last eighteen months as the huge deficits have meant that the bond market became the funding source for Federal payments for services and transfers. When you have to roll-over more than half the outstanding debt every year, plus raise another trillion dollars or more, there is no rest for the guys at the Treasury working on new bond issues.
Each bond issue is sold to the same list of ‘primary dealers’ who underwrite all Treasury and Agency sales. Those dealers then turn around and sell the bonds to the public or to institutional buyers. The exception to this rule is foreign central banks, who deal with the Treasury directly. At recent auctions, foreign central banks have been buying a larger share of new issues as their foreign currency reserves have been swelling due to protracted US trade deficits and they too have huge balances to roll-over.
The market for US Treasury bonds seems to have plenty of demand to absorb the huge issues of new bonds, notes and bills. The share that is in TIPS is still fairly small versus the totality of the Treasury debt. But, since all the TIPS are longer than five years at issue, the share of TIPS keeps growing slowly.
One would think that the extremely low level of interest rates would entice the Federal government to extend maturities as much as possible. Currently, the entire US Treasury debt has an average maturity of a little more than 4 years. Just about half of the debt is in Treasury bills with final maturities of no more than one year. Two-year and three-year notes are the next most popular maturities, so the volume of longer-dated bonds is fairly modest really. We’ve gone from selling 30-year bonds twice a year to every other month and we’re selling 10-year notes every month instead of just once a quarter, but even with record issue sizes and an accelerated pace of issues, the long end of the Treasury debt isn’t growing all that much.
In the short-run, financing at the short end keeps the cost of the debt minimal. Why pay even 2.5% for ten-year paper when you can borrow for a few basis points with bills? The Federal Reserve may keep short-term rates very low for a while yet, which may give the Treasury time to modestly extend maturities, but once the demand for Treasuries is sated, rates will rise and all those very cheap bills could be very expensive someday.
Issue of the Week
Everyone is all in a conniption over the outlook for QE2, no not the ocean liner or the actual person but the prospects for quantitative easing the second time around. The Federal Reserve is expected to announce next week after their next policy-setting FOMC meeting a program of quantitative easing that will hopefully improve the outlook for the US economy.
Quantitative easing is the economics slang for the Fed buying assets on the open market as a way to force-feed the economy more money. It is widely viewed as the second best tool in their arsenal of weapons to stimulate the economy. Directly setting interest rates is their most formidable weapon, QE is next. They also can use capital requirements and other regulatory means to encourage or discourage lending, or, good old-fashioned moral suasion – jawboning people into doing what they want.
The question is how much QE and will it be effective. A report from Goldman Sachs said they expect the QE2 to be huge, perhaps in the range of $2 trillion to $4 trillion over a year to a year-and-a-half. The very next day, the Wall Street Journal guessed that QE2 would probably start out slowly, with maybe $500 billion in purchases over six months and could be extended or expanded as the need arose. We’ve seen Bill Gross of PIMCO Total Return fame chime in with his outlook that QE isn’t likely to dramatically alter the outlook for the economy. Also, Jeremy Grantham (the Grantham in Grantham, Mayo, Van Otterloo, or GMO) argues that QE never really works and that most monetary reactions create as many problems as solutions and should be done only as a last resort.
The markets are all watching closely as all the markets, stocks, bonds and currencies will be affected if QE is a lot bigger or a lot smaller than expected. A lot of QE is expected to lower the value of the dollar. Insufficient QE could cause the economy to slow and also lower the value of the dollar. This is another of those damned if you do, damned if you don’t situations. The dollar is arguably the most important consideration in the investment markets these days. The huge ‘dollar carry trade’ reacts to changes in the dollar with opposite and offsetting changes in many other ‘risk’ assets. We will probably know first of any change in policy with violent reactions in foreign markets, US stocks and bonds, then the Fed will tell us what it is going to do.
Existing home sales were reported as a huge gain this past month. The National Association of Realtors said sales rose 10% in September from August. The sales rate, at 4.53 million homes at an annual rate, was the highest since the expiration of the first-time home-buyer tax credit in April. The gain was far above the expectations of Wall Street’s economists and surprised many who thought housing would languish at a low level for a while yet. The lower price of homes may have helped as the average home price was $171,700, a drop of 2.4% from the August level.
New home sales jumped 6.6% in September. This marks the second month in a row that new home sales have gained far more than Wall Street’s economists had expected. The gain comes with no tax incentives or even very many more incentives from the builders. That pace of 307,000 at an annual rate is still far below the level that a healthy US economy would generate, but it is an improvement. It is also well below the pace from last year.
The S&P Case-Shiller Index of home prices fell for the first time in five months in August. The decline of 0.2% was worse than expected. S&P called the report disappointing and argued that the beneficial impact of the home-buyer tax credit has worn-off. 15 of the 20 cities in the index showed declines in home prices.
The Federal Housing Finance Agencyreports that house prices rose 0.4% in August from July. In the past twelve months, the price of a home whose mortgage was bought by Fannie Mae or Freddie Mac fell 2.4%. This survey covers only ‘conforming’ mortgages bought by the mortgage finance agencies and has some overlap with the Case-Shiller data above, but covers much more of the country outside the 20 major metropolitan areas covered by Case-Shiller.
GDP in the third quarter grew at a 2.0% annual rate according to the Bureau of Economic Analysis. That is generally in line with Wall Street’s expectations, maybe a tad light. The bulk of the growth came from consumption with business investment spending also adding to growth. Government expenditures grew faster than the broad economy. Inventories grew by 1.4%, adding to growth but also are likely to slow growth in the future as we work-off those inventories. Final sales, which exclude the impact of inventories, rose only 0.6%. Real disposable income rose 0.5% while the savings rate fell to 5.5% from 5.9% in the second quarter.
The United Kingdom reported surprisingly strong GDP growth in the third quarter, 0.8%. If this is surprisingly strong, don’t even think about what weakness would be. The expectation among economists was for a gain of less than half of one percent. In a show of what is different between the US and Europe, the Bank of England is now expected to scale down their plans for monetary easing due to this number. 0.8% is just not good enough in the US, but is fine for Britain.
Consumer Confidence as reported by the Conference Board rose in October to 50.2 from 48.6 in September. The gain was wholly centered in higher expectations for the future while the outlook for the labor market remains horrid. The overall level is depressed.
Consumer Sentiment as reported by Reuters and the University of Michigan fell to 67.7 in October from 68.2 in September. The slow pace of the recovery has kept many consumers pessimistic about the outlook.
Not surprisingly, with this week fast approaching, the market spent a lot of time anticipating last week and not a lot of time doing anything. Sure, there was some jostling around when unexpected news came out. We had the unexpectedly good home sales news, but that was largely off-set by the poor consumer confidence numbers. The decent GDP report was off-set by the relatively uninspiring durables report. Not a lot to get us going either way. So, we ended the week with little change in the large cap or the small cap spaces. The NASDAQ did show up with a gain of over 1%, largely on stronger earnings from almost every company that reported.
This week, we have the elections of course, but also the Fed meets Tuesday and Wednesday with their announcement of QE2 on Wednesday. The payroll report is Friday and we get the Purchasing Managers on Monday (hint it was pretty good, better than expected). We expect the market to get jerked around by the news flow this week whether the news is good, bad or indifferent.
Foreign markets were not so encumbered, but didn’t go very far anyway. A little dollar weakness didn’t help or hurt. The developed markets sagged with widespread weakness in Europe and Japan. The emerging markets were all over the place from losses in Hong Kong and Korea to gains in Mexico and Brazil. Surprisingly good news on manufacturing in China this morning has given those markets a real push today.
US bond markets were mixed, with Treasuries losing at the long end and corporates gaining at the lower quality end. Most high grade bonds felt selling pressure as Bill Gross announced the end of the thirty-year bull market in bonds. Most foreign bond markets were weaker, but some emerging markets showed strength. Brazil’s bonds especially as Brazilians went to the polls on Sunday to elect a new president.
Real estate securities generally faltered, with US REITs faltering more and foreign REITs faltering a lot less. Commodities were mixed with the energy segment showing weakness but most other areas strength.
Have a great week
Karl Schroeder, RFC, CSA
Investment Advisor Representative
Schroeder Financial Services