Will All Yields Go To Zero?

A fellow in my investment group issued this challenge:

“ I know many of you yawn but you cannot explain the insatiable demand for short maturity US Treasuries at almost 0% yield as stocks and gold and oil soar “

The context of this challenge is the new lows reached today by the two year and three year US Treasury notes of 0.41% and 0.62% yields. What could cause such unprecedentedly low yields given the price of gold and oil, both soaring, normally a marker for inflation and growth. It is an important question and here is my attempt at an answer.

Yes I think I can explain it, but the explanation leads to your same negative conclusion.

What is going on in the two year and three year is much more important than what happens to the 10 yr US Treasury benchmark rate. This is not just about investors. It is about them, but it is more about those entities that make real investment, hard asset investment for profit, in business infrastructure, equipment and real estate.

Since the onset of the financial crisis, they no longer see the derisked ROI necessary to pull the trigger because the level of uncertainty is too great. Its too great because the macro economic numbers and their customer sales aren’t robust enough and because of what they see as a lack of confidence by governments in their ability to deal with the current problems.

So they sit on the funds. That means putting the money in UST securities, because that is the place to put money to have the greatest probability of getting it back. As these funds have piled up they have “used up” the available pools of the 3 month, then the 6 month, then the one yr, etc., like a cascading waterfall in a hotel lobby. Now they are filling up the 3 year pool. When that is full they will go on to the 5 yr.

Obviously the larger the problem, the more pools will be filled up. As long as the conditions for real investment remain the same we will continue filling up more of the pools.

I believe Bernanke and the Fed see the same situation and therefore reason, if they can increase the ROI by lowering the cost of long term capital they can jump start the economy through real investment. This will prove impossible because there is not enough ROI to be gained by reducing corporate borrowing costs, when the real problem is increasing perceived rate of return before cost of capital is subtracted. The perceived rate of return would have to be increased much more than there is available by just reducing borrowing costs.

So it is a conundrum. Eventually this lack of investment will lead to further deterioration in the rate of growth from our already low rate. I fear what these numbers are telling us is we are already in a state of Japanese style long term zero growth. There is no way to tell whether it will be longer or shorter than the Japanese two decade problem.

My hunch is it will be shorter because the Japanese problem was made worse being an export economy with relatively smaller domestic demand. The export driven growth when it slowed left relatively more fixed asset investment in place to be absorbed over a smaller base of domestic demand.

Of course, recognizing this may lead to worse rather than better investment returns. I have found recently it is better to act without regard to this potential for loss than remain in a bunker all the time, even if eventually proven correct. Armed with this belief and a grounding in economics I hope to and expect I should be able to switch gears quickly when it becomes necessary.



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