Treasury Bills Yielding Zero Make 1938 Moment…..Buyers Beware

Posted By on November 22, 2009

Bills Yielding Zero Make 1938 Moment

By Liz Capo McCormick and Daniel Kruger

Nov. 23 (Bloomberg) — For the first time in seven decades, Treasury bills are paying no interest while stocks continue to appreciate — a divergence in U.S. financial markets that might be perilous if Federal Reserve Chairman Ben S. Bernanke didn’t know all about 1938.

That’s when the Standard & Poor’s 500 Index climbed 25 percent even as bill rates tumbled to 0.05 percent from 0.45 percent. As 1939 began, stocks began a three-year, 34 percent decline after the Fed increased borrowing costs prematurely to stymie inflation that never materialized.

While almost no one expects Bernanke, a self-described “Great Depression” buff, to raise rates before mid-2010, bond investors say with unemployment above 10 percent and housing taking another downturn, they have no qualms about lending the government money for nothing to ensure their capital is preserved. Stock investors, meanwhile, say the worst is over and that low borrowing costs coupled with the $12 trillion 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.”

Three-month bill rates closed at 0.005 percent last week, down from 0.11 percent at the end of September and the year’s high of 0.34 percent in February. Traders said the rate dipped below zero on some bills due in January on Nov. 19.

As money poured into bills, the S&P 500 ended little changed on the week at 1,0931.38, up 64 percent from the low this year of 666.79 on March 6. The S&P GSCI Index of 24 commodities rose 46 percent this year, rebounding from last year’s 43 percent slump. Investors in high-yield, high-risk, or junk, corporate bonds earned a record 52 percent this year, according to Merrill Lynch & Co. indexes.

“A lot of these markets have been driven by excess liquidity and are not necessarily supported by economic fundamentals,” said Thomas Girard, a managing director at New York Life Investment Management who helps oversee $115 billion in fixed-income assets. “Clearly there is a class of investors that are nervous,” said Girard, who is avoiding bills and instead buying high-rated corporate bonds.

Bernanke, who has been studying the causes of the Depression since he was a graduate student at Massachusetts Institute of Technology, said on Nov. 16 that it’s “not obvious” that asset prices in the U.S. are out of line with underlying values. He didn’t address asset prices outside of the country. In 1989, he wrote an article 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.

“It is inherently extraordinarily difficult to know whether an asset’s price is in line with its fundamental value,” Bernanke said in response to audience questions after a speech in New York. “It’s not obvious to me in any case that there’s any large misalignments currently in the U.S. financial system.”

Equity investors say they have history on their side. The S&P 500 rose an average 8.4 percent in the six months before the last five increases in the Fed’s target rate for overnight loans between banks and added another 82 percent 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.

The median estimate of 60 economists surveyed by Bloomberg News is for policy makers to keep their target rate for overnight loans between banks in a range of zero to 0.25 percent until the third quarter of 2010.

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