If you rewind the financial big-picture tape over the last seven years and then hit replay, you will see money gushing like a springtime Colorado mountain stream into stocks, then to real estate, then to commodities and finally in record amounts to Treasury bonds for safety. Do we have a Treasury bond bubble now, and will it eventually burst like the other bubbles before it?
The following facts support my bubble theory:
1) Current 10-year Treasury note yields are less than inflation. The fear in the market caused by falling stock prices and financial institutions in trouble has created a flight to safety so dramatic that the traditional inflation premium has disappeared. During the past 12 months, inflation at the consumer level has been 4.2 percent and 3.2 percent at the wholesale level. At the time of this writing, the 10-year Treasury note yields only 2.5 percent and has risen from just over 2 percent. These yields do not make sense unless a major deflationary period is ahead, which is unlikely given the projected size of our deficit.
2) Current agency bond yields have followed Treasury yields downward and generally yield much less than your bank’s bond portfolio’s average yield. In the past, this has been a powerful signal of an overbought bond market and therefore a warning signal to avoid buying long-term securities in large quantities as you are betting against all your previous bond decisions.
3) Premiums on mortgage-backed securities are rising sharply again. The Federal Reserve has announced that it will purchase about $500 billion in mortgage-backed issues between January and June to further liquify owners of these types of securities and also encourage lending activities. The effect of this dramatic and unprecedented move should be that yield/risk spreads continue to narrow and mortgage rates should fall, thus creating a wave of refinancing like 2003. Are these additional prepayment possibilities factored into the amount of premium being paid?
4) The temptation to reach for yield now is strong. One of the basic handicaps of bank investing is that we always have too many funds to invest when rates are low and margins are under pressure and never enough cash when rates and margins are most attractive. This is especially true now as good loans are difficult to find because of credit conditions and the Fed has lowered the fed funds rate to essentially zero.
In my opinion, the White House, Fed and Treasury are doing the right thing by pulling out all of the financial stops now to avoid a deep recession or worse. Of all of the inflation forces, deflation is the worst outcome because consumers simply stop purchasing goods as they did in the 1930s.
Besides cutting rates, they have employed many innovative balance sheet initiatives to restore confidence and jump-start the economy. My hope for 2009 and beyond is that the air from the Treasury bond bubble can be released in a rapid but orderly fashion once the economy starts recovering … hopefully soon.
Best wishes for a prosperous 2009 and a special thanks to BankNews for the privilege as I begin my 20th year of writing in this space.
Jeff Goble is executive vice president and managing director, investment banking, at UMB Bank, n.a., Kansas City. His email address is Jeffrey.Goble@umb.com.
Copyright © February 2009 BankNews Publications