A Truly Ghastly Environment

November 25, 2009
This is a truly ghastly environment for yield-conscious investors. Three-month T-bills yield 0.03%, two-year T-notes 0.73%, five-year T-notes 2.09%, and ten-year T-notes a whopping 3.3%. Who is locking up money for ten years at a 3.3% yield? The Fed’s balance sheet is bloated with reserves, and the federal government is running massive budget deficits. Isn’t this inflationary? You betcha. But the combination of an extremely steep yield curve and the Federal Reserve’s promise to leave the fed funds rate near zero for an extended period of time has created a massive carry trade in the treasury market. Long rates are being kept artificially low because the yield curve is so steep. They likely won’t move much higher with short rates near zero. Why? It’s too profitable for investors to borrow short and lend long without taking credit risk. A commercial bank can borrow near zero and lend to the U.S. government for five years at a 2.09% yield. Levered ten to one, this trade results in a 21% return on equity. If long rates aren’t likely to move higher until short rates rise, should you extend the maturity of your bond portfolio to pick up yield? Of course not, you would be speculating on interest rates. Savvy investors have learned to do exactly the opposite of what commercial banks are doing. Stay short.