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14 December, 2008

Deflation Keeps Credit Tight, Treasurys Popular


With deflation still a possibility, credit markets have a hard time loosening up


Investors know the future will bring either inflation or deflation, but they can't decide which. So they're erring on the side of a worst case scenario, keeping the credit markets in a stranglehold and Treasury notes extremely popular.

Despite a moderate rise in the stock market Friday, the yield on the two-year Treasury note hit another record low, falling to about 0.76 percent for the first time since the note has been issued.

Adding fuel to the argument that the economy is headed for deflation, the Labor Department said its Producer Price Index, which tracks costs of goods before they reach consumers, fell 2.2 percent last month -- more than anticipated -- as gasoline and other energy prices retreated.

Government debt becomes more attractive in weak, deflationary economies not only because the assets are safe, but also because the returns are in fixed dollar amounts -- so when deflation occurs, they actually rise in value. This reduces the incentive, to some extent, to buy riskier, higher-yielding assets like junk bonds.

"The main driver of the credit markets, at one level, is inflation versus deflation," said Jack A. Ablin, chief investment officer at Harris Private Bank. When there's inflation, Treasurys become less attractive and investors look for assets that will offer higher returns.

The outlook for prices is murky right now, keeping investor demand for safety high and hurtling rates on riskier debt higher and higher. The government's huge issuances of debt should cause inflation, but a steep, prolonged recession would be deflationary. It's a quandary that's paralyzing investors.

"Are we really going to get significant deflation? If we are, it has one set of implications, and if we're not, it has an opposite set of conclusions. It's kind of a binary environment right now," said Jay Mueller, portfolio manager, Wells Fargo Advantage Funds.

"If we have severe deflation, Treasurys are going to continue to be the preferred place to be," Mueller said. However, "it's hard to make these determinations because we don't have much track record to go on."

The last sustained period of deflation in the United States was during the Great Depression. The benchmark 10-year Treasury note's yield, at 2.58 percent on Friday, isn't that far off the yield on similar debt in the 1930s -- a little over 2.1 percent, according to Global Financial Data in Los Angeles. (Later, in 1945, yields fell as low as 1.55 percent.)

But the 10-year note's yield could have a lot farther to fall if Japan is any indication.

After Japan's stock and real estate bubble burst in the late 1980s, the nation went into a very long slump, and yields on the Japanese government's 10-year note in 2003 fell as low as 0.46 percent, according to Mueller.

"Japan has had 10 years of deflation at this point. I doubt that it's in the cards for us, but it does show how low yields can go in a deflationary environment," Mueller said.

Yields on longer-dated Treasurys continued to hover near their recent historic lows. The 10-year note rose 8/32 to 110 6/32 and its yield fell to 2.58 percent from 2.66 percent. The 30-year bond rose 16/32 to 128 1/32 and its yield fell to 3.05 percent from 3.08 percent.

The three-month Treasury bill's yield was 0.04 percent, up from 0.01 percent but still indicating high levels of demand for safe, short-term assets. The discount rate was 0.02 percent.

As investors swarm to government debt, they are also starting to snap up mortgage-backed securities -- which is helping actual mortgage rates fall -- and some are buying high-grade corporate debt again.

But speculative grade, or junk, bonds are seeing demand tumble even further.

"One of the things I'm a little worried about with high yields is it's a self-sustaining situation," Ablin said. A company's ability to get new funding is reliant on their rating, and their rating is reliant on their financial health. There's a worry, Ablin said, that the junk bond market "collapses on itself."

Over the past month, bonds for investment-grade companies have gained more than 4 percent, according to the iShares Investment Grade Bond Fund, but junk bonds have fallen more than 11 percent, according to the Lehman High Yield Bond Exchange Traded Fund.

And when prices fall, rates rise, making it more expensive for the companies to issue debt. Standard & Poor's said Friday that speculative-grade rates, as compared to Treasury rates, broke through records Thursday, surpassing 17 percentage points.

About half of all rated companies have a junk rating.

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Posted by fxgenbroker 19:49 | ForexGen Partnership,, economy | Comment(0) | Permalink

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