Perilous potential of divergence in US financial markets
Treasury bills are paying no interest while shares continue to appreciate
FOR the first time in 70 years, US government Treasury bills are paying no interest while shares continue to appreciate -- a divergence in US financial markets that might be perilous if Federal Reserve chairman Ben Bernanke didn't know all about 1938.
That's when the Standard & Poor's 500 Index climbed 25pc even as bill rates tumbled to 0.05pc. And, as 1939 began, shares began a three-year, 34pc decline after the Fed increased borrowing costs prematurely to stymie inflation that never materialised.
While almost no one expects Mr Bernanke, a self-described Great Depression buff, to raise rates before mid-2010, bond investors say that, with unemployment above 10pc and housing taking another downturn, they have no qualms about lending the government money for nothing, to ensure their capital is preserved.
Stock market investors, meanwhile, say the worst is over and that low borrowing costs coupled with the $12 trillion (€8trn) of fiscal and monetary stimulus will bolster earnings.
"The question is what are you going to do with all the money that has been created?" said James Hamilton, a former visiting scholar at the Fed who teaches at the University of California, San Diego.
"It's not a contradiction at all to see very low short-term yields and at the same time have people trying to buy stocks. They are both reflecting that same force."
Mr Bernanke, who has been studying the causes of the Depression since he was a graduate student at Massachusetts Institute of Technology, wrote an article in 1989 with Mark Gertler, a New York University economics professor, for the 'American Economic Review', in which they presented a detailed model that helps to explain the cascade of events that led to the collapse of markets in the years after the 1929 crash.
Obvious
"It is inherently extraordinarily difficult to know whether an asset's price is in line with its fundamental value," Mr Bernanke said in response to audience questions after a speech in New York this month.
"It's not obvious to me in any case that there's any large misalignments currently in the US financial system."
Equity investors say they have history on their side. The S&P 500 rose an average 8.4pc in the six months before the last five increases in the Fed's target rate for overnight loans between banks, and added another 82pc in the bull markets that followed, according to data compiled by Bloomberg.
Shares typically rise before central banks push up interest rates because markets anticipate economic expansion first.
Even so, bond investors doubt the strength of the recovery after the US Federal Housing Administration said last week that foreclosures on prime mortgages and home loans insured by the agency rose to three-decade highs in the third quarter.
Builders broke ground on 529,000 houses in October, down 11pc from September and the fewest since April's record low, US Commerce Department figures showed last week.
"Everything is not dandy in this world," said Axel Merk, who manages more than $550m as president of Palo Alto, California-based Merk Investments and has been buying bills.
"Sure money is flowing into risky assets and people are leveraging up, but it is only available to those with pristine credit.
"It is still a very difficult environment for people to function in and many would still rather hold government bills."
"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 that 0.05pc," Jim Bianco, president of Bianco Research in Chicago, said.
"There is still tremendous demand for the front end of the curve despite the fact that people are saying things like there is no yield there and that cash is trash."
Speculative
Finance officials in Japan and China, Asia's two largest economies, said last week that the Fed's monetary policy risks spurring speculative capital that may inflate asset prices and derail the global economic recovery.
The central bank's target rate has been between 0pc and 0.25pc since December. Fed officials are stepping up scrutiny of the biggest US banks to ensure the lenders can withstand a reversal of soaring global asset prices, informed sources say.
Supervisors are examining whether banks such as JPMorgan, Morgan Stanley and Goldman have enough capital for the risks they take, and how much they know about the strength of their counterparties.
"At some point reality is going to bite us in the backside," said Michael Cheah, who manages $2bn in bonds at SunAmerica Asset Management in Jersey City, New Jersey.
"We are living in the best of times and the worst of times.
"Unfortunately the best of times cannot continue celebrating like this when the economic fundamentals are worsening rapidly."
Irish Independent
