Investors have been paying the US government to look after their money again.
To be more specific, the yields on some short-term Treasury bonds (US government debt) have fallen so far (ie prices have risen so much) that they’ve turned negative or almost flat. In other words, some investors are paying for the privilege of lending to the US government.
That’s unusual. In fact, the last time yields went negative, was in December 2008, shortly after the Lehman Brothers bankruptcy and the ensuing panic. At that point, you could perhaps understand why investors would be so scared as to overwhelm the US with demand for its debt. But why have yields turned negative now?
The short answer is that nobody knows. But whatever the reason, it can’t be good…
Are we heading for another slump?
The yield on three-month Treasury bills is practically flat (0.005%) and in some cases actually went negative last week. No one’s entirely sure why investors are willing to pay the US government to lend to it. But in the past it’s never been what you’d call a good sign.
There’s the case following Lehman Brothers noted above. And before that, the last time we saw negative or near-flat rates alongside a rising stock market, was in 1938, according to Bloomberg. That year the S&P 500 index rose by 25%, reports Bloomberg, while Treasury yields fell to 0.05%. In 1939, after the Federal Reserve raised interest rates, stocks began a “three-year, 34% decline”.
So what’s going on? Are we heading for another slump?
Well, not necessarily. Banks have been pushing up demand for short-term government debt. That’s because they like to unwind riskier trades and tidy up their balance sheets for the benefit of regulators and investors by loading up on government debt before the year end. This is known as “window dressing.” And in fact, this was cited by some analysts as a key factor when Treasury yields went negative around about the same time last year. So it’s happened before.
Meanwhile, the US government is also trying to reduce its reliance on short-term funding by selling more long-term debt and less of the short-term stuff. Companies are also issuing less commercial paper (which is also short-term debt, mainly used for working capital purposes).
So in short, the number of safe places to stash your short-term cash is down, while demand for such havens is up because it’s close to the year end. In other words, negative yields on short-term debt aren’t quite as mad as they look.
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You should still tread the markets with caution
But that doesn’t mean everything’s just fine and dandy. Volatility may be relatively low for now, but we are living with a financial system that’s anything but normal. As Jim Bianco of US firm Bianco Research puts it on Bloomberg: “We cannot spin a positive story from the fact that a third-of-a-trillion dollars a week is trying to lock down Treasury bill yields of less than 0.05%”.
A note from David Parkinson at RBC Capital Markets points out that another factor pushing yields lower has been renewed concerns over the banking system. Recent reports from credit ratings agencies Standard & Poor’s, Fitch and Moody’s have all warned that banks across the globe have problems ranging from still-inadequate capital levels to an over-reliance on short-term financing.
And of course, another sign that all is not well with the financial system is the fact that gold keeps hitting record highs. As my colleague Dominic Frisby pointed out yesterday (Three ways to tell when gold’s bull market is over), this makes sense when you realise that cash is now a depreciating asset.
But it’s yet another reason to tread with caution. As Bill Gross of the world’s largest bond investor Pimco puts it, the Fed is using monetary policy to try to force people out of cash and into riskier assets. However, Gross is not bullish on the outlook for the US economy. He talks of a ‘new normal’ where economic growth is weak, profits are low, and government involvement in the economy is high for the foreseeable future. None of that makes risky assets such as equities sound very attractive.
The best sector to buy for a low-growth economy
But at the same time, if the world’s central banks are going to persecute you for being in cash, then what can you do? He suggests that, as “the future American capitalistic model is likely to resemble” the regulated, low-growth business model of a utility company, then you might as well buy utilities. You get a decent income, and a company that is fairly insensitive to economic changes, because people need power and water come what may.
Gross is talking to US investors, but over here in the UK, the same pretty much applies. We’ve been tipping defensives (economically-insensitive stocks) pretty much since the market bottomed in March, and while most such sectors have gained at least some ground, they’ve still underperformed the market. Electricity generators have been particular laggards. Andrew Lapthorne at Société Générale picks out National Grid (LSE: NG), which currently offers a prospective dividend yield of just under 6%, while trading on a p/e of 11. That looks attractive to us.
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