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The Shin Bone Is Connected to the Knee Bone...
By: Dr. Charles Lieberman
Date: 7/13/2009
The full power of the Fed's strategy to keep overnight money near zero to get a recovery going is finally working its way through the entire bond market, driving down yields on longer maturity Treasuries, but also driving down the yield on all corporate debt. Checking and savings deposits pay zero or a few basis points, 90-day T-bills pay less than 20 basis points, and money market funds little more. This works only as long as investors remain fearful. As fears of Armageddon dissipate, investors must buy either longer maturity Treasuries or corporate bonds to get any yield whatsoever. Slowly, this is also driving down those yields, reducing borrowing costs for high grade companies, but also for high-yield companies. And it is this decline in yields that is critical to the economic recovery.
Just a few weeks ago, many investors thought that the Fed was able to exert control over the cost of overnight money, but the steepening yield curve, at least measured by Treasuries, proved beyond any doubt that markets controlled long-term rates and that environment was becoming antagonistic to mortgage and other refinancing activity. The truth was more subtle. Long-term Treasury rates rose sharply, as investors became less inclined to go for safety and more inclined to find yield. However, corporate bond yields kept on declining at the same time. Such disparate movements in rates really proved that fear were declining, which made it easier and cheaper for companies to get financing. This thawing of the credit markets is crucial to economic recovery prospects.
In the past few weeks, Treasury yields have fallen again in response to mixed economic data and the need for yield. So Treasury yields fell, but high grade bond yields fell even more, as those spreads also kept declining. Now, high grade bonds with maturities under 10 years are under 6%, while high yield bond yields are also still falling. In fact, we no longer find high grade bonds attractive for investment, because the yields are now too low. Most importantly, companies are able to refinance and lock in credit for long periods into the future at ever more reasonable costs.
The implications of these developments are very positive for the equity market and the economy. Corporate spending plans collapsed as companies froze spending to retain liquidity in 2008. Now, they can get back to business. International trade, hampered by disappearing trade credit, can now flow more easily. Business inventories are falling unsustainably and production must rise to keep level with demand. Activity is turning around. Patience is required, but this bodes well.
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