Bond Yields Rise . . .
. . . But Risky Investments Climb
More than a year ago, Alan Greenspan noted that the persistence of low interest rates for long-term US bonds presented a “conundrum” when the Fed was steadily raising short-term rates. Until recent weeks, this conundrum continued. In the latter part of 2003, 3-month treasury bills yielded 1% and 10-year treasury bonds yielded 4.5%. In the beginning of this year, 3-month bills yielded 4.5% and 10-year bonds still yielded 4.5%.
During this period, Japan’s central bank was pursuing a zero-interest rate policy to put an end to Japan’s stubborn deflation; the European central bank maintained an accommodative, low-interest rate policy. Indeed, it was not until June 2004 that the Federal Reserve Board began its long, slow process of raising short-term rates by baby steps. The easy-money, low interest rate policies of these central banks encouraged investors to make riskier investments, and, taking the cue, investors poured capital into risky investments. The result now is that almost all investible assets trade at high prices, at least when measured by traditional risk standards. It has been increasingly hard for Core to find undervalued investment assets with good prospects.
Things may now be changing: last week, the yield on the ten-year treasury exceeded 5% for the first time since 2002. Last month, Japan’s central bank announced the end of its policy of “Quantitative Easing”. The European central bank has begun to raise short-term rates. Thus, for the first time in years, the world’s three major central banks are all pursuing restrictive monetary policies. Japan has not yet begun to raise rates, but its announcement tells us that rate rises are on the way.
The investment effects of tight money policies. The eventual investment outcomes are clear; the timing of these is utterly opaque. Long-term US interest rates will rise further. The dollar will fall in value. The prices of risky investment assets will better reflect their real risks. (Should emerging-market debt be priced to yield less than Fannie Mae’s mortgage-backed debt--with its implicit US government guarantee? No.)
BRIC and Petro-Dollars--or Why Timing is Impossible. When will risky assets fall in price? Will ten-year treasury bond yields continue to rise, or will yields first fall back again to 4.5%? One can have opinions about this, but the timing is unknowable. Many factors--factors that have kept US interest rates low, and that have rewarded investors in emerging market debt and other risky assets--persist today. So long as these factors outweigh the effects of rising short-term rates and other coordinated tight-money policies by the three major Western central banks, yields will stay low and prices of risky assets will stay high.
The acronym “BRIC” refers to Brazil, Russia, India and China. Until recently, the economic effect of these countries was limited to the political risks they posed from time to time to America, Europe and Japan. But now, as we know, the economies of these countries have taken center stage in the world. Their accumulation of foreign reserves through ever-expanding trade surpluses now amounts to at least $1.3 trillion. Of similar magnitude are the trade surpluses and foreign reserves of oil exporting countries. Relentlessly high oil prices and ever-expanding demand for oil have given OPEC countries (and non-OPEC oil exporters like Russia) enormous inflows of dollars. Foreign reserve accumulation by the OPEC and BRIC countries and the free flow of this capital around the world have transformed investment markets in ways not imagined a decade or two ago.
“Non-economic” investors. The anomalous feature of BRIC and OPEC capital is that decisions about investing it are “non-economic”. Private investors like us make investment decisions with the idea of achieving the highest total return consistent with the risk level we tolerate. By contrast, central banks--including the Western ones--invest their capital primarily to achieve desirable economic and political effects for their countries. For example, China’s central bank uses much of the surplus it generates through its trade to buy US treasury bonds. This is in China’s interest: it has the twin effects of (a) keeping down the value of China’s currency in dollar terms and, (b) by keeping US interest rates low, thereby stimulating US consumer demand for Chinese products. This is a non-economic investment decision in that it causes China to put too much money into an overpriced asset, namely US treasury bonds. However, the political and other economic benefits to China are deemed to be greater than the investment risk it assumes in holding so much of its capital in US treasuries.
Because non-economic investors control so many trillions of dollars, their investment decisions skew investment markets in ways that may be considered irrational. Back to our China example: if China continues its very large purchases of US treasuries, then treasury bond yields will stay low. If Japan continues its weak-yen policy, the dollar will remain strong against the yen. So long as these conditions are in place, the prices of risky investment assets will appreciate and the gap between those prices and their “real” values will widen further.
What will change the pricing of risk? When OPEC and BRIC countries change their capital allocation and reduce the rate of investment in US treasuries and other dollar-based assets, interest rates here will rise, perhaps significantly. The dollar will fall in value, particularly against major Asian currencies. Inflation in the United States will rise; the economy here will slow. Financial markets around the world will be less forgiving of investment risk and far more volatile.
Our solution. Because three-month treasury bills, the “riskless” investment, yield essentially as much as ten-year treasury bonds, one should reduce investment in bonds and keep the proceeds in money market funds, both US dollar money funds (the usual ones) and non-dollar money funds. One should reduce holdings in other risky assets that have risen well above their “real” values. Although the timing of a repricing of risk is uncertain, it does lie ahead of us. When it comes, those holding cash (in dollars and other currencies) will have attractive investment opportunities. This is Core’s approach; we have begun to put this into effect.