Monday, November 23, 2009

The Curious Case of Negative Yields

Certain Treasury bill rates briefly dipped into slightly negative territory in the last couple of days, which constitutes a pretty extraordinary phenomenon by any measure. This essentially means that investors are willing not only to forgo any interest on such holdings but are willing to pay in order to get their hands on Treasury bills that mature in January 2010.

Part of the reason for this highly unusual, and counter intuitive situation is of a somewhat technical nature and associated with an emotional reaction of the market to comments made by a Fed official late last week.

St. Louis Fed President James Bullard expressed the view that the Fed should keep its program of mortgage-backed securities purchases in effect beyond the currently planned time frame of March 2010 and also implied that, based on the pattern of how the Fed has reacted in past cycles, the central bank may refrain from tightening for as long as another two years. Although views expressed by individual Presidents of regional Federal Reserve Banks often do not reflect the FOMC's mainstream view, Bullard's comments triggered some excitement in the front end of the Treasury market, which, in turn, caused a scramble to close in a hurry any previously established short positions. The result was a wave of impulsive and technical buying that pushed yields briefly into below-zero territory.

However, there is something disconcerting about all of this insatiable demand for liquidity. At its core, lies the lingering fragility of the banking system and a strong need for institutions to fortify their balance sheet for year-end purposes with the safest-quality paper available. It is hard to forget that the only other such episode of negative Treasury bill yields in modern history occurred in December 2008 (and, in the case of the 1-month bill, in March of this year as well), right in the midst of the wave of anxiety and risk-aversion sweeping the financial system in the post-Lehman period. In this latest phase, bill rates had already been drifting lower in recent weeks, ultimately leading to the piercing of the zero percent level in the last couple of days.

The absence of any headline-making negative news about the financial system in the last few months is by no means tantamount to banking institutions' returning to an even passing semblance of soundness. Banks are still vulnerable, undermined by the vast majority of their toxic assets that they still carry on their balance sheet (despite a moderate rebound in some of the underlying markets), and the imperative for year-end, window-dressing operations remains as pressing as ever.

Anthony Karydakis