Through TheFLY's Eyes: Money Matters

from Theflyonthewall.com









A new column by Theflyonthewall.com

Editor’s note: In our new “Money Matters” column, look for incisive commentary on this blog featuring a summary and analysis of the week’s most important issues affecting money, markets, and investing. It’s no-nonsense analysis timed to arrive when you have the time to read.



The Conundrum

Now that U.S. economic growth has started to slow, there hasn’t been much discussion about “the conundrum.”

For those of you who haven’t followed the markets and investing recently, “the conundrum” is a phrase made popular by former U.S. Federal Reserve Chairman Alan Greenspan and refers to the relatively low, long-term interest rates prevailing in the United States, particularly in the bond market.

As of June 16, 2006 at 11 a.m. EDT the interest rate for the 2-year U.S. Treasury Note stood at 5.12%. Extend the bond out 30 years and the rate doesn’t increase much: The 30-year U.S. Treasury Bond is hovering around 5.13% Economists call that a flat yield curve. During a typical economic expansion, the interest rate rises the longer you invest (or lend) money.

Further, in an environment of high U.S. government spending, and large budget deficits, this lack of a higher long-term interest rate has puzzled economists and market analysts alike – so much so that former Fed Chair Greenspan called it “A conundrum.” Even the venerable Greenspan couldn’t figure out why, despite considerable debt, the U.S. wasn’t paying a higher price with substantially higher long-term interest rates. In fact, up until recently, long-term interest rates had been at their lowest real levels in about 30 years.

Hence, the question remains, is today’s below-average interest rate environment a trick or an appropriate stance by the market? Since many economists and analysts on Wall Street have argued for the former we’ll present the case for the latter, or ‘Three Reasons For The Conundrum.’

1-Savings glut – Globally, there’s a surplus of savings. The world is awash in cash. That’s a somewhat paradoxical statement for U.S. readers, because the U.S.’s savings rate has been very low for several years, so there’s no savings surplus among U.S. citizens. But the world, as a result of strong economic growth in the developing world – China, India, Brazil, Russia – has ample savings – more savings than they can productively invest at home – and a considerable portion of that money is flowing into the U.S.

2-Institutional demand – Institutional demand, primarily pension funds and other payout-oriented institutions such as insurance companies, have and are likely to continue to create a strong demand for U.S. Bonds. These institutions will face increased payout demands as the Baby Boom generation starts to retire in 2010-2011. As a result, they require investments that have a stable, dependable payout – with U.S. Treasuries and other bonds being at the top of their list.

3-China – Finally, there’s the booming Chinese economy. As noted, the developing world is growing solidly, but no economy is growing like China’s. Mainland China has been growing at or near 10% for about 10 years – a phenomenal feat that’s created a vast amount of wealth in the country. Further, much of that wealth is being re-circulated to - you guessed it – the U.S. in the form of investments in U.S. Treasuries.

The net effect of the above? Above-average capital flows into the U.S. and above-average demand for U.S. bonds has depressed interest rates below what they would be in a typical economic expansion. In effect, foreign investors are helping to subsidize U.S. borrowing. They’re a major reason why the rate on 30-year U.S. Treasury notes is hovering around 5.10% and not 6.50%.

The impact on typical investors? Most analysts would argue that the savings glut and interest rate “conundrum” has lengthened the current economic expansion and/or delayed a recession. Further, since a growing economy is almost always good news for stocks, the savings glut has boosted stocks and investors’ portfolios. Hence, it’s not a stretch to state that the DJIA’s current 11,000 point value has been supported, to some degree, by “the conundrum.”

Still, the conundrum is not simply a win-win for U.S. investors, i.e. a one-sided development. There is a down side: many economists argue that the global savings glut is a temporary, not permanent economic condition, and that U.S. interest rates will rise when conditions shift from one of relative capital surplus to tighter capital conditions. Further, some economists argue that the U.S. risks incurring an abrupt, large increase in interest rates if, for example, a major bond holder such as China or Japan loses its appetite for U.S. Treasury investments.

And those last two points are items investors and traders should keep in mind. But that’s not to say that bond investment patterns will change anytime soon. To be sure, thus far there is little indication that foreign investors are losing their appetite for U.S. Treasuries, so at least for the time being, the conundrum continues.