Commentary: Where Have All the Good Times Gone?

Look Harder — They May Be Here

Van Halen captured the moment when they belted out the lyrics, “Where have all the good times gone?” I am fairly certain they weren’t singing about investing in the front end of the Treasury yield curve. Nevertheless, the question remains: Where have all the good times gone? This is what money market investors have been asking lately. Treasury bills, or T-bills, are perceived to be one of the least risky investments, and in recent days, this market has traded at levels that confirm this belief. Government support and full liquidity obviously come with a premium price tag; however, does the premium warrant near zero or negative yields?

For the first time since the aftermath of Lehman, T-bills are trading at zero and sometimes at negative levels. When Lehman went bankrupt, it made sense that a flight to quality would follow, with investors cashing out of corporate and high-yield bonds and moving into Treasuries, driving yields down. At that point in time, the yield earned on the investment was furthest from investors’ minds as they sought shelter from the credit market storm.

Times are different now...right? Risk appetite is back, regardless of whether it’s a natural occurrence or fabricated by the Federal Reserve (Fed). So, why are investors willing to receive paltry returns or, in some cases, pay to lend the government money for a stipulated time? This occurrence is even more unusual because the equity market continues to appreciate while yields in the T-bill market make a push toward zero — a relationship that has not been seen for decades.

In Exhibit 1, the shaded area represents recessionary periods. It is easy to understand that there would be an increased demand for T-bills when the economy is faltering or is expected to falter.

Exhibit 1: Three-Month T-Bill Yields, 2000-Present

Source: Bloomberg. Red dots denote recessions.

Right now, this is not presumed to be the case. The U.S. economy is showing signs of recovery and is expected to continue in that direction. Likewise, financial markets have come a long way toward stabilization and are likely to continue to do so. Recovery may slow from its robust pace, but it should continue to move forward, with markets and the economy eventually regaining their full strength.

So, why are rates at near-zero levels? There are many factors that play into the direction of the T-bill market and interest rate levels; however, it seems that there have been three factors recently playing havoc within the market:

1. The Federal Open Market Committee has orchestrated an abnormally low federal funds rate, holding the overnight rate in the range of 0 to 25 basis points. A flight to safety and a lack of inflationary pressures are common contributors to the low level of rates. Since we expect that the Fed will hold rates steady for the foreseeable future (likely until the latter part of 2010), rates in the front end should remain low and rangebound.
2. Current levels show that the expansion will probably be muted going forward.
3. As rates remain low and uncertainties exist in the near term, companies and banks are looking to the bill market to bolster their cash position and repair their balance sheets. As a result, demand has increased, driving prices higher and yields lower.

The fact that equity markets are moving higher is a sign that investors are willing to take on additional risk. It also means the Fed is accomplishing one of its goals—to drive money out of the front end of the market into riskier assets. It’s not all about the cash on the sidelines or the push from the Fed, though. Corporate forecasts continue to be revised higher, a sign that companies feel the economy is improving. Cost reductions have helped fuel recent positive earnings revisions, as companies make improvements in their overall bottom lines. At some point, we need to see top-line growth pick up to levels needed to continue to help corporate profits. As profits, the economy and markets improve, front-end investors should get some reprieve from near-zero yields.

The End Game

These extremely low T-bill levels do not have to be a worrisome signal, even though this might seem counterintuitive. Like many economists and investors, my crystal ball is cloudy at this point in time. There are many scenarios that could play out. The two common extremes are strong GDP growth in upcoming quarters or a double dip with the economy back into a recession. The likely outcome is that growth within the economy and market will be somewhere in between the extremes.

There is no doubt that we will see some setbacks on the road to recovery. This was witnessed recently with Dubai World looking to delay payments on $60 billion of debt, creating renewed concern of default risk. Hopefully, this is an isolated incident and not the start of another credit crunch. The probability of another banking crisis with the magnitude of the one we just experienced, with global banks and financial institutions closing their doors and creating a wave of panic and defaults, is very low. The Fed and its counterparts have implemented measures to instill confidence and prevent another global credit and liquidity crisis.

Regardless, recent events have had an immediate and measurable impact on the front-end investor, which is visible directly through incredibly low money market yields and represented in the minuscule discounts and yields that are tied to owning individual bonds. Although yields for T-bills, like cash instruments, may remain low for the foreseeable future, the likelihood that they remain negative for a prolonged period of time is unlikely. There will come a time when the fixed-income markets start to forecast additional economic growth and tightening monetary policy. This anticipation will push yields higher, helping the front end of the yield curve resume some sense of normalcy.

This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice. This information is for educational purposes only.

There are risks involved with investing, including loss of principal.

SEI Investments Management Corporation serves as investment advisor for SEI Global Fixed Income Management.