“Risk free” rate going way of free lunch
One of the many comfortable but unreliable certainties now coming unglued is the idea that U.S. Treasury interest rates are the paramount benchmark, a measure of “risk free” investment, an idea at the heart of finance.
In the old days we quaintly believed that U.S. government debt yields represented a benchmark against which all other types of risk taking could be measured. The 30-year yield, later supplanted by the 10-year, used to be called the most important rate in the world for just that reason. All other risk taking began from this handy jumping off point and all capital allocation decisions used it as an implicit or explicit input.
That role of the benchmark of benchmarks, which greases the wheels of finance making it more “efficient” but more prone to spectacular error, is now under attack from a number of directions.
In retrospect, it seems clear that artificially low interest rates, due in large part to Treasury purchases by China seeking to keep its own currency and exports competitive, helped to turbo charge risk taking during the boom.
Living in a world of “low” interest rates and eternal moderation, investors didn’t realise how much risk they were taking on when they sought extra return above government debt, and after a while the money was so good they didn’t really care. In combination with credit ratings, another failed benchmark, that helped to fuel the boom.
Now we are living with the bust and coming to realize just how useful and dangerous benchmarks are.
“Nowadays it would be too much to ask for benchmarks. We all have to make our decisions on the basis of our own perceptions of the situation,” said Stephen Lewis, economist at Monument Securities in London.
Well and good, but as you can see the result of us all making our own decisions based on our own very limited data about how much risk there is in the world or in a given investment is abject terror
and an inability to act: much less risk taking.
People are only really willing to lend or invest in what they truly know, and as we each individually or as institutions know very little, we will invest very little and at, for the economy, ruinously high rates.
100 TIMES MORE RISK
The U.S.’s benchmark status as a “risk free” borrower is based on the idea that it is the best available credit, a solid gold borrower that will not default. And of course as Treasuries are denominated in dollars and as the state ultimately can print money to fulfil its obligations, that is correct.
But investors clearly are becoming increasingly spooked that the United States’ difficult situation and its absolutely huge borrowing plans are making it a less certain risk.
It now costs 60 basis points a year to buy a five-year credit default swap insurance policy against U.S. sovereign default, up from about 15 basis points in August and 100 times more than in January 2007 when it was 0.6 basis points. Clearly, somebody thinks risk free isn’t so risk free any more.
This compares with a 50 basis point cost for German or Japanese debt.
And remember too that 5-year Treasuries are only yielding about 1.70 percent, so a hedge against default would eat up quite a lot of one’s return.
Ironically, the Federal Reserve’s potential strategy of buying up government debt to reliquify the economy and avoid deflation may just make things worse.
Federal Reserve chairman Ben Bernanke last week said the Fed could directly purchase “substantial quantities” of longer-term securities issued by the U.S. Treasury or government-sponsored agencies to lower yields and stimulate demand.
Fair enough, and it’s not as if I have a better plan for jump-starting the economy, but having the state buy up Treasuries will only put more distance between a genuine “risk free” rate and reality. Investors will be even more in the dark about what and where risk is. They will not know where Treasuries would trade without Fed intervention, nor will they know when and how quickly the Fed will roll back that intervention when growth and inflation inevitably arise again.
That may sound like a technical point, but it is extremely serious. It seems likely to me that investors will alternate between two poles: totally terrified and unwilling to take any risk, and too giddy and scared to miss out. My guess is that this policy will extend the first state and turbo-charge the second.
Lack of confidence in benchmarks will keep people frozen longer, and make them float another bubble when at last they come round.
The failures of the past 10 years are failures of misallocation of capital; first the dot-com bust, then housing.
It is very hard to know what to root for: another bubble or deep, deep recession as investors, stripped of all their illusions, advance capital only to what little they actually know.
— At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click here. —