Friday, November 21, 2008

"nervous investors sought sanctuary from the turbulence in equities and other asset classes."

Here's more evidence of the Flight From Risk going on in the FT:

"The spectre of looming deflation drove government bond yields on both sides of the Atlantic to historic lows on Thursday as nervous investors sought sanctuary from the turbulence in equities and other asset classes.

Some US Treasury bills were quoted at 0 per cent, while the two-year note and the 30-year bond recorded their lowest yields since they were first regularly issued in the 1970s. The five-year note was at its lowest since 1954, based on historical data from the Federal Reserve. In the UK, the two-year gilt yield dropped to its lowest level since since the second world war."

So, people are buying bonds with no interest in order to buy a government guarantee that their money is safe. Does this even make sense?

"Buying government bonds as a safe haven investment has dominated flows in recent months. The latest moves come as increasingly worrying economic data point to rising unemployment and plunging inflation.

“Given the recent deflationary data, not just in the US but globally, the world is starting to build in a Japan-style deflationary scenario,” said Jim Caron, head of interest rate strategy at Morgan Stanley."

It can make sense in a time of Deflation, since your money is essentially appreciating in value because you can now buy more with it at cheaper prices. Is Deflation even realistic given the Fed?

"Recently, the Federal Reserve’s effective Fed funds rate has traded at around the 0.25 percentage point level, well below the target rate of 1 per cent. Meanwhile, Treasury inflation securities have moved to price in deflation for the next nine years.

Bill O’Donnell, strategist at UBS, said the bond market was reacting to the very low effective Fed funds rate and the possible start of a deflationary period. “The mood is ‘give me Treasuries at the expense of all other asset classes’ as spreads blow out and stocks slump,” said Mr O’Donnell.

Tom di Galoma, head of Treasury trading at Jefferies & Co said: “There is no place to hide but in US Treasuries. You cannot hide in corporate or mortgage bonds.”

So, investors are buying US Treasuries because they're the safest bet, and are willing to get almost nothing for that. It's hurting investment because investors are avoiding corporate and mortgage bonds, read loans. TIPS see deflation for 9 nine years. Is this even realistic?

"Deflation fears drove the 30-year swap rate to more than 50bp below that of the 30-year bond yield. Some investors are using swaps rather than buying bonds to keep their cash reserves intact as they seek greater exposure to long-term rates.

“If you already have a portfolio, using swaps allows you to increase duration without liquidating cash bonds,” said Jay Mueller, portfolio manager at Wells Capital Management."

So there's a rush into Swaps to maintain liquidity to be able to purchase long term rates, read more interest.

"The demand for long-term debt pushed the 30-year bond yield to a new record low of 3.71 per cent on Thursday; the two-year note traded as low as 0.96 per cent."

That shift to government backed long term bonds have driven their interest rate down. Supply and Demand. There's a large supply of fear, and a demand for less risk. But is this rational?

“This is about the collapse of inflation from official numbers this week and the very real spectre of disinflation in the UK,” said Moyeen Islam, fixed income strategist at Barclays Capital. “We expect yields will go lower as inflation is likely to be negative between May and October next year.”

The yields on the two-year German Schatz fell to levels not seen since September 2005. Yield spreads between Germany, the most liquid and deepest bond market in Europe, and other eurozone countries, also widened as it continued to outperform."

Since I don't fear deflation, as opposed to a drop in prices for a short period of time, and always fear inflation, I consider this behavior to basically panic behavior, based on the more unlikely scenarios going forward. Time will tell if I'm being foolish. But, given my beliefs, you can see why I believe that the Fear and Aversion to Risk at the expense of ignoring fundamentals and the most likely outcomes is our main problem now, and we need to attack these fears with incentives and moves to encourage risk.


No comments: