The ballad of little “i”

Scott Burns of Morningstar looks at the role of interest rates (little “i”) in the investment universe

As a fresh decade gets underway there is one thing that is dominating the thoughts of investors and traders alike: interest rates. In my younger days as an investment banking analyst, a vice president told me that it took him 10 years in the business to realise that the most important data point in any valuation was the 10-year Treasury bond rate.

Now, that vice president was not dense by any means. It is so easy even for the most seasoned analysts to get caught up in forecasting and estimating all of the other factors that go into valuing stocks, bonds, and commodities that they tend to forget the one constant in all of those evaluations. 

Whether it is oil prices or the valuations of regional banks, somewhere in the equation the almighty interest rate shows up, usually in the form of the 10-year Treasury bond rate. The title of this article refers to the fact that in valuation equations, this interest rate is expressed as a little “i.” Believe me, little “i” is there in every pricing model whether it is the capital asset pricing model (CAPM) for stocks or the Black-Scholes formula for options. At the highest levels, all investments in risk assets are measured by the return you are getting versus a risk-free investment in US Treasury bonds.

I was fortunate to get this piece of advice in the early years of my career, and it is a lesson that has proved invaluable through bubbles and busts alike. So often in the thick of either of these swings we spend so much of our time examining individual investment ideas and holdings that we miss the bigger picture. It is the classic “forest for the trees” problem. Given where interest rates are right now, having a good understanding of the “forest” is as important as ever.

Gauging little “i”

Hopefully, you are aware that Treasury yields are at or near all-time lows. Especially short-duration Treasury bonds, or what we refer to in the business as the short end of the yield curve. How low is it? There were days in December when the three-month Treasury bill went negative. Now, that is something that we could reasonably expect to see in a period of market panic like March 2009, but December was a great month in the stock market, so panic doesn’t explain it.

We might also expect to see this in times of deflation and, although we aren’t in an inflationary bubble, we aren’t in a deflationary spiral either. In fact, if we look out further on the yield curve and compare 10-year Treasury rates with 10-year Treasury Inflation Protected Securities (TIPS) rates, we see that, at times, inflation was the only thing that was getting priced into Treasury bonds, at around 2.25%. Essentially, the US government is borrowing money for nothing on a short-term basis and only for a modest inflation rate in the long-term. More importantly, the billions of dollars invested over the past few months in Treasury bond ETFs are making next to nothing. The same goes for the trillions of dollars invested in money market funds and other Treasury bond funds.

Why so low, little “i”?

I generally don’t subscribe to conspiracy theories, but this is less conspiracy theory and more policy theory. The government is keeping interest rates low for a simple reason: to help the banks out. Nobody benefits more from a steep yield curve than banks. Check the interest rate on your savings account and compare that with mortgage rates, and you will see who the big winners are here. When you remember that the US government is the largest stakeholder or backer of these institutions, you can see why it is in their best interest to keep this game going.

The other reason is that investors are still scared. We are talking about massive amounts of money here, so this isn’t the average person on the street that is still scared. No, this is pension funds, sovereign governments, and endowments that are pushing all of this money into Treasuries, although I’m sure individual investors are doing their part, too. We have been seeing some risk metrics, such as corporate bond spreads, tighten but even with the market rally, there is still a lot of money on the sidelines.

The other fear is inflation. We’ve talked a lot about this, but the amount of money moving into gold, TIPS, and short duration bonds is beyond what even inflation-hawks like ourselves would deem warranted.

Treasuries: the new bubble

I know, you can’t take another bubble, but here we are again, staring another one in the face. You think a market full of intelligent investors would eventually learn its lesson, but I’m afraid that bubbles and busts are inevitable.

This isn’t exactly news to anyone who has been following our portfolios. We took the drastic step of repositioning the Hands-Free Portfolio just so we could kick Treasuries out of it. While we are glad that we made that move when we did, the activity in the Treasury bond space since then has been shocking. As I see it, we have all of the necessary ingredients on the counter to make a bubble burst sandwich. A flood of money rushing into an investment type; prices at all-time highs; returns for new investors approaching all-time lows; and pundits, like me, calling it a bubble. 

Little “i” on the march

Eventually these deep-pocketed investors are going to get sick and tired of making 0% on their money. More likely, well-paid fund managers are going to have to start explaining to people why they aren’t generating any returns. Also, the banks are going to repay their Trouble Asset Relief Programme (TARP) money and the Federal Reserve is going to start pumping up interest rates to combat inflation. When that happens, cash is going to come flowing out of Treasury bonds and it is going to look for places to invest that actually make money.

Greed and fear are the two spectrums of the market pendulum, and my 2010 prediction is that we will see the pendulum swing back to greed and money will flow out of Treasury bonds and money market accounts. We’ve already seen some of that in the “junk rally” of 2010. Before anyone cries, “Wait a second, we just had one of the greatest market rallies ever,” let’s not confuse a stock market going from the brink back to some semblance of normality as a sign of greed. That was just a return to normal from a very precarious edge that we nearly tipped over.

The “junk” that rallied the hardest was in areas that could have been awash in bankruptcies if the credit markets didn’t loosen up. Quality has continued to lag, and there are still ample investment opportunities, especially for longer-term investors.

Finishing up my 2010 predictions, the junk rally will unwind. Hedge funds are currently shorting quality names and using that money to prop up these “junk” equity prices. We know this is happening because the short-interest in the Consumer Staples SPDR funds has been hovering around 60%. When those hedge funds start heading for the door, the junk is going to drop and the quality is going to pop. Even if the S&P doesn’t move a tick from its current levels in 2010, it won’t mean that there won’t be major winners in losers.