Interest Rate Pain

The views expressed in this column are solely those of the author and do not reflect the views of SVB Financial Group, or Silicon Valley Bank, or any of its affiliates.  

Now I'll tell you who I am
I'm the repo-man
And I'm looking for the joke
Looking for the joke
I'm looking for the joke with a microscope
- Iggy Pop  

Returning to the desk this week after an absence combined with both jury and family duty, I must agree with Iggy — I'm looking for the joke.

The punch line, of course, is yields.

Treasuries maturing in 30 days have dropped from the 0.05 - 0.10 percent range to the 0.01 - 0.02 percent range. Overnight repurchase agreements (or "repo") spent last week at zero.

These are odd price movements considering the number of people arguing for inflation pressures and spiking Treasury yields. But there are several things going on that might explain this slight, though important, drop in yields. Among them:

1. The arbitrage big banks have been able to exploit by borrowing in the repo market at around 0.05 - 0.10 percent and placing the proceeds at the Fed earning 0.25 percent is now officially dead. The new charges applied to banks for FDIC coverage apply to total assets less Tier I capital as opposed to deposits. Executing this arbitrage expands a bank's balance sheet, thereby increasing the fees owed for insurance just enough to erase profits. This means banks will reduce their activity in the repo market (providing collateral), which drives yields down.
2. Given the debt ceiling issues faced in Washington, the Treasury has been reducing the Supplementary Financing Program which, effectively, was $200 billion of short-term bills it issued to provide liquidity for the Fed. This reduction in supply of short-term Treasuries has driven yields lower, but should be reversed as the debt ceiling is raised. There is no doubt it will.
3. The Fed's purchases of outstanding Treasuries drives down both Treasury rates and repo rates as these bonds are sucked out of potential collateral pools. This will also be reversed, but only once the Fed is ready to begin reducing its own balance sheet.

It is surely good news that two of these three are reversible and the other was really artificial support in the first place. But in the meantime, investors are suffering.

In graduate school, they taught us the next step after a richening of any asset class would be a flood of investors shifting to alternate investments until prices readjust to a "normal" relationship. In this case, investors should move from the safe haven of Treasuries into less safe or less liquid investments in order to capture the yield difference.

Like a waterfall, some investors shift to government agency bonds (Fannie/Freddie), highly rated corporate bonds, or even unrated investments that are deemed to be "safe" such as bank deposits. They might even take their money out of the markets entirely by enacting new capital expenditures as the opportunity cost in the form of savings return declines.

But in the real world, money doesn't shift so naturally. For our client base, this possibility is even smaller. Since our typical client will not have its earnings or cash flow change significantly with small changes in yield, many are opting to remain in Treasury or Treasury-like investments regardless of return. None of ourclients have expanded their investment set to include lower than "A"-rated securities since at least 2008. Treasuries, for many, are the option of choice today.

But there are also companies for whom an extra 0.30 or 0.50 percent can make a significant difference in their business operations. For these clients, there are still strategies to employ that achieve capital preservation and liquidity, but also address that third objective in their investment policies — return.

Fortunately, today's low yield levels look to be temporary, given their cause is temporary. Suffering lower yields for short periods of time is the price investors pay for placing such a high value on capital preservation over return when there is a "flight to quality" or a reduction of supply in this asset class.

But make no mistake, yields will normalize. And as the recent rate increase in Europe implies, recovery will bring about interest rate hikes in the U.S.

In the meantime, it is important that you are not losing money on your investments after fees. No investment manager focusing on cash should place you in that position in any market.

Key Developments

Consumer prices rose driven by food and fuel in March, while other prices decreased, supporting Bernanke's stance that the increase in commodity prices will not cause inflation to spike. The consumer price index, excluding food and energy which are volatile inputs, increase 0.1 percent over the last month, less than the projected 0.2 percent.

Wholesale costs in the U.S. rose 0.7 percent in March, led by higher prices for energy, light trucks and passenger cars. The increase in wholesale price was less than anticipated as food prices dropped unexpectedly for the first time since August. The core measure, which excludes volatile food and energy costs, increased 0.3 percent, which was more than forecast.

More Americans unexpectedly filed first-time claims for unemployment insurance last week, reflecting greater-than-normal volatility at the end of the quarter. Applications for jobless benefits rose 27K in the week ended April 9 to 412K, the most in two months. The four-week moving average, a less volatile measure, rose to 395K from 390K.

March U.S. retail sales rose for the ninth straight month, despite concern that price increases for fuel and food could stifle retail spending. Purchases increased 0.4 percent following a revised 1.1%. Declining unemployment and a cut in payroll taxes for 2011 are helping to support sales at chains like Macy's and Saks.

The Federal Reserve said the U.S. economy expanded at a "moderate" pace across much of the U.S. in February and March, led by manufacturing with labor markets showing improvements in most regions. Some districts reported that uncertainties remained high with seven districts citing disruptions to sales and production from recent events in Japan. The report also noted that while higher commodity costs compelled sellers to try to raise prices, pressures to increase wages remained subdued.