Risk may be the new new focus in the capital markets these days after the recent turmoil in equity markets around the globe, but the price of risk isn’t exactly compelling when measured by yields in debt securities.
With the 10-year Treasury yield under 4.6% at the moment, there’s little incentive to rush in and buy if the goal is holding until maturity. Nearly half of the current yield is slated to evaporate into the ether of inflation, based on the latest measure of annualized consumer prices.
Meanwhile, we’re in no mood to reach down into lesser-graded debt in search of higher yields. Moody’s Baa-rated corporate bonds (the lowest rung of investment-grade debt) last week were yielding around 6.16%, or about 166 basis points over 10-year Treasuries. As our chart below shows, that’s the slimmest risk premium for Baa over the 10 year since the late-1990s.

There are, of course, rationales for the relatively slim compensation handed out these days in exchange for loaning money to the Feds and corporations. Direct your eyes to the red line in the above chart. The yield curve remains inverted, meaning that short interest rates (defined here by Fed funds) are higher than long rates (10-year Treasury). Reflecting that capsized state of affairs in the price of money, the red line (which measures the 10-year/Fed funds spread) is firmly below zero, as it has been since mid-2006.
Of course, for investors convinced that the United States is headed for a recession in the foreseeable future, the prospect of buying a 10-year Treasury or an equivalent maturity in corporate bonds holds some appeal, even at the reduced levels. A stumble in the economy would likely compel the Fed to cut interest rates, which would soon dispense capital gains in the short term to holders of debt securities. Lower interest rates, in fact, are the stuff that dreams are made of when it comes to the measuring happiness among the fixed-income set.
But we’re not entirely convinced that the economy’s about to take the plunge. Our own reading of momentum in the economy (based on a proprietary index of various economic factors) continues to suggest that the path of least resistance is moving sideways with a slight bias to the downside. Robust growth doesn’t appear imminent, but neither does a terrifying collapse. Although we expect the economy to slow, it won’t slow enough to compel the Fed to cut rates dramatically.
In fact, looking at Fed funds futures contracts through the September series suggests that the market has limited expectations of a rate cut any time soon. Inflation is still too high and the economy still too strong. Yes, the outlook could change, perhaps as soon as this week, when consumer prices for February are updated on Friday. But for now, we’re content to favor money market accounts at 5%-plus until the future looks clearer. Being paid to wait won’t win us any accolades at cocktail parties, but it helps us sleep at night after the celebration’s over. One day our risk appetite will change, but just not today.

2 thoughts on “NO APPETITE FOR RISK

  1. frank

    Anyone with usd investments of any class is taking more risk than they need to. In our lifetime we are going to see the usd recede vs various other monetary measures. But don’t go searching for shangri-la since the fiat money system approach (with fractional-reserve banking systems) ishere stay, absent a supervolcano, massive meteorite impact or global thermonuclear war. Carry on.

  2. Agustin Mackinlay

    Good post, Mr. Picerno. What needs to be explained, though, is HOW the inverted yield curve drains liquidity. Here’s an idea. If lower demand for credit leads to less demand for bank reserves, the Fed faces only two possible choices. It either validades the new, lower Fed funds rate, or it DEFENDS the existing target by selling Treasuries (thus reduging the monetary base).

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