Bubble Revisited

“Yield spread” sounds like something you might smear on a toasted bagel, but only if you were really hungry. It’s not.

Yield spread is simply the mathematical difference between a specific kind of bond and a treasury bond of the same maturity. For example, the yield spread between a 10-year corporate bond yielding 5% and a 10-year treasury note yielding 3.5% would be 1.5%, or “150 basis points over treasuries.”

Generally speaking, yield spreads narrow (“tighten”) during strong economic times and widen during recessionary times. That’s because fixed-income investors become more confident in low-rated credits during boom times than when times are tough…and Treasury bonds lose their safe-haven appeal. As a rule of thumb, therefore, most investors consider tightening yield spreads to be both a coincident indicator of economic growth and a harbinger of growth to come.

Lately, yield spreads have been tightening. So…is this a harbinger of growth to come? Or is it merely the result of yield-hungry investors buying up riskier bonds in a “grope for yield”?

ContraryInvestor.com offers a compelling argument in favor of the latter interpretation. In other words, just because yield spreads are tightening, don’t think that economic recovery has arrived.

Historically, yield-spread differentials widen during tough economic periods, because there is often an accompanying flight to the perceived quality and cash-flow safety of U.S. Treasurys. This naturally bids Treasury prices up and yields down.

Over the past few years, the fixed-income markets have witnessed some very wide – even extreme – spreads between the yields on Treasury securities and those on main-line corporate and high-yield debt. The yield spread between Moody’s Baa-rated corporate debt and the 10-year Treasury peaked late last year at a level not seen since the early 1980s.

However, the spread between Moody’s Baa note yields and 10- year Treasury yields has contracted by 75-plus basis points since late last year. Over the last six to seven months, yield spreads between what is considered risky debt and safe U.S. Treasurys have continued to contract…during a period in which U.S. Treasury yields have also continued to decline to levels seen maybe once in a generation.

Which brings us to a very important question for those trying to read today’s financial markets. Does the “yield-spread” contraction truly signify a better economic environment ahead? Or are investors – shocked by the low absolute level of yields available in safe fixed-income investments – simply “chasing yield” in higher-risk securities? What do we look for when trying to get a sense of whether collapsing credit spreads are correctly forecasting an economic recovery, anyway?

Consumer spending patterns are a good place to start. If indeed the economy is shaping up, consumer spending on discretionary items should also improve. Unfortunately, recent retail spending and retail-sector corporate reports leave little to be cheerful about.

But in addition to watching consumer spending, we should be keeping a pretty sharp eye on commercial lending activities, too.

A recent commercial-bank survey of senior loan officers revealed that these officers have significantly relaxed their standards for making loans relative to their 4Q 2002 responses. But the big question for banks is whether they are relaxing corporate lending standards because they genuinely believe that corporate credit quality, and general economic conditions, are improving…or instead – as we’re tempted to believe – because the pressure to grow their top lines is so great, they’re willing to lend more freely just to achieve some growth in their own businesses.

Commercial-bank lending to corporate borrowers peaked on an absolute dollar basis in February 2001. As you might guess, it took the bankers a little time to get comfortable with the idea that the party on Wall Street and in the real economy was ending. Since then, it has been straight downhill in terms of bank-sponsored corporate loans outstanding. Total corporate loans outstanding have dropped by 14%-plus, or $156 billion.

On a year-over-year rate-of-change basis, this cycle’s contraction in commercial-bank corporate lending has no precedent in at least two-plus decades. But if the tightening of credit-market yield spreads really foreshadows an economic recovery ahead, we should at least be seeing bank lending to corporations beginning to turn up.

As the Fed and the U.S. non-bank credit system throw the liquidity levers into hyper-drive, the yield curve is flattening – not an environment in which the banks can simply coin money by buying bonds with their deposits and then take the rest of the day off. In essence, by accommodating supercharged liquidity in the system, the Fed is forcing the banks to lend if they want to grow their revenues…And yet, corporate lending is falling!

The biggest reason of all why yield spreads are contracting may be that mom-and-pop America is simply starving for yield. Diligent savers across the U.S., dependent on interest income for their living needs, have seen their incomes destroyed over the last three years. And because of the need for adequate absolute return, folks are clearly “reaching for yield” in the current environment.

Inflows to American bond mutual funds help explain a lot of what is happening with credit spreads. As of this writing, $63 billion has come into bond mutual funds so far this year – a record figure. Meanwhile, equity funds have taken in only $2 billion, and money market funds have seen a $29 billion outflow.

Like equity-fund managers, bond managers also feel performance pressure – in this case, one basis point at a time. The higher bond prices go in the short term, the more these managers will surely feel the pressure to become more fully invested.

Clearly, it’s taken the public a good while to “find” bond funds. And they are doing their best to pile in at what are multi-decade lows in terms of yield. Main Street is chasing yield with what seems like little regard for credit quality or longer-term interest-rate risk. In addition to the accommodative environment fostered by the Fed, Main Street is also feeding the bond market monster.

Add to the mix that foreigners are still financing the massive U.S. trade deficit by snapping up dollars. And in many cases…like, say, Japan…they’re ploughing them into U.S. Treasury bonds.

The resulting situation in today’s fixed-income market bears an uncanny resemblance to that of stocks in late ’99 and early 2000. After all, everyone chasing an asset in simultaneous fashion is what usually characterizes a mania, right?

If these parallels hold, tightening credit-market yield spreads won’t be helpful at all in predicting an economic recovery. But one thing they may help to predict is a bubble top – this time in credit-market debt.

Warm regards,

Eric Fry,
The Daily Reckoning
June 4, 2003

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“There is a very low probability of deflation,” said Alan Greenspan in Berlin yesterday. (But the Fed chairman hinted that he might cut rates again, as “insurance.”)

“The chances of inflation reemerging in the near future are quite small,” said the same man on the same day in the same place.

So you see, dear reader, there is nothing to worry about. Nothing at all. After 30 years of the Dollar Standard, we have finally reached a kind of monetary perfection. An economic Valhalla. The Elysian Fields of finance.

Heh…heh…

We can almost hear Eisuke Sakakibara cackle.

Japan’s former Finance Minister recalls a similar time, about 10 years ago, when his dynamo economy seemed to be getting back into the swing of things after the stock market tumbled. Back then, he must have been confident, too. As near as anyone could tell, he and his cronies were making all the right moves. Interest rates were lowered. Liquidity was added. Government spending was boosted. Inflation was low. Bonds boomed…and stocks rallied. Just like the U.S. today.

But making money and credit more readily available didn’t refloat the Japanese economy. Instead, the extra money piled up on the decks and capsized it. Rather then throw them overboard, bad investments and bad companies were given mouth-to-mouth resuscitation and kept alive. The new money merely added to capacity – which drove prices lower.

Bonds boomed again yesterday in America. Yields fell to record lows. Thirty-year treasuries were priced to yield only 4.36%.

If inflation rates rise significantly, bond investors will be wiped out. Just as they were in the ’70s. But, like Greenspan, they see no threat from inflation.

On the other hand, if inflation rates slump into deflation, stock market investors will be wiped out. Consumers will stop consuming. Borrowers will stop borrowing. Companies will lay off employees. And profit-making corporations whose stocks are traded on Wall Street will have fewer profits to show investors. But, like Greenspan, stock buyers see no menace from deflation.

Meanwhile, the money supply soars. M1 – cash plus checking accounts – is increasing at a 30% rate. M2 is rising at about the same rate. Dollars bulge from vaults and mattresses all over the world.

Maybe Mr. Greenspan will be wrong about deflation. Or maybe he will be wrong about inflation. Or maybe he will be wrong about everything.

While we wait to find out, here is the latest from Wall Street, brought to you by Eric Fry:

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Eric Fry in New York…

– Poor Martha Stewart; she may be heading off to jail without a supply of “400-stitch percale” prison dungarees. TV’s Duchess of Decorum is engaged in a very “mussy” criminal investigation and, rumor has it, faces an indictment in the near future. Her company’s stock, Martha Stewart Living Omnimedia tumbled as much as 19 percent after the unseemly news crossed the wires.

– Like sour milk in a crème brûlée, the distasteful news about Martha Stewart seemed to “ruin everything” for investors yesterday morning. But like any capable homemaker, investors wiped the tears from their eyes and salvaged the day as well as they could. They bid the Dow to a 25-point gain at 8,923, and whisked the Nasdaq to a 13- point advance at 1,604.

– Investors also resumed nibbling on government bonds. The 10-year note’s yield dropped to 3.33% from 3.41% on Monday. The dollar advanced slightly against the euro to $1.173, while gold retreated 80 cents to $366.30.

– Yesterday, we asked ourselves, “How confident – or nervous – ought the nation’s homebuilders feel?” To judge from the nation’s unemployment trends, homebuilders ought to feel nervous…very nervous. (Making matters worse, Martha’s Stewart’s homes might soon be on the market).

– Yesterday, Alan Greenspan, himself, admitted that the job market has yet to show consistent signs of improvement. Of course, it’s no secret that the nation’s employers are continuing to shed jobs at a furious pace – 525,000 non- farm payroll positions in the past three months alone. Over the last two years, 2.1 million jobs have disappeared from U.S. payrolls. – “The total number of people unemployed – including discouraged workers who would prefer to work, but have stopped looking – is about 9.2 million,” the Hartford Courant reports. “And the number of people who are working part-time because they can’t find full-time work is 4.8 million, up 46 percent since 2001, according to the Bureau of Labor Statistics.”

– And the job search isn’t getting any easier. The Conference Board’s Help-Wanted Advertising Index – a key barometer of America’s job market – declined three points in April. The Index now stands at 35, down from 38 in March. It was 47 one year ago.

– Not surprisingly, therefore, the average search time for re-employment has been on the rise for seven consecutive quarters. The average search time stretched in April to a 17-year high of nearly 20 weeks – that’s up from about 12 weeks in early 2001.

– “Clearly, businesses have been busy laying off workers and scaling back already greatly reduced plans to hire,” says Conference Board Economist Ken Goldstein. “If the overall economy remains weak heading into the third quarter, a return to job growth earlier than the fourth quarter doesn’t seem likely.”

– These grim employment statistics issue forth from an economy that emerged from recession 16 months ago, according to the nation’s fully employed economists…And yet, the housing market booms.

– So far, generation-low interest rates and easy bank lending practices have combined to support housing prices. But job growth would be a welcome addition to the mix. Unfortunately, unless the hundreds of thousands of laid-off autoworkers and manufacturing employees can find gainful employment as economists, the housing market may run low on eager and capable buyers.

– Making matters worse, high-paying manufacturing jobs continue to disappear at a rapid clip. According to the Bureau of Labor Statistics, there were 62,429 mass layoffs in the factory sector in April, up from 50,897 in April 2002.

– However, there is a ray of hope on the horizon – you see, we ALWAYS try to look on the bright side of things here at the Daily Reckoning, even if we don’t always find it. The number of ANNOUNCED layoffs by U.S. employers fell 53 percent in May, the lowest level since November 2000, according to outplacement firm Challenger, Gray & Christmas.

– Maybe there’s hope for the housing market after all.

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Back in Baltimore…

*** House prices are still rising. In the first quarter, they rose at a 6.4% annual rate – the smallest rate of increase since 1999. Home sales are hitting new records. So are home mortgages. Fannie Mae says this year’s total is up 42% over last year – to $3.7 trillion.

*** Home prices and apartments are rising in Argentina, too. But they’ve got a long way to go. A colleague reports he just bought two very nice apartments in one of the best areas of the city – one for $169,000, and another for $200,000. In Paris or New York, apartments like these would easily sell for up to $2 million each.

“Argentina won’t be this cheap for very long,” opines our friend Leif Simon – who, as editor of Global Real Estate Investor, has spent time scouring the Argentine market for bargains in the wake of their currency’s collapse. Leif says he has seen first-hand that prices have started to rise…and believes Argentina will see as much as 100% advances over the next three years.

*** Editor’s Note: If you’re at all interested in buying deep-value property in Argentina, you may benefit by participating in a “conference call” scheduled this afternoon at 2:00pm EST, organized by the Diligence group.

Participating in the call will be Dr. Steve Sjuggerud, who, if you’ve been following his comments here in the Daily Reckoning, you may know has been following the Argentina situation very closely for the past 3 years. Lief Simon will also be in on the call, as well as Paul Reynolds, the head of the top residential real estate firm in Argentina.

They’ll be talking to the directors of a company that owns over 50 developments in the capital city of Buenos Aires. (It owns all 6 of the major shopping malls in the city. And almost all of the residential and office towers there, too.) Millennium Partners, a consortium of some of the world’s best investors, bought a $150 million stake in the company…the shares of which can still be purchased on the NYSE for under $10.