Something's Got to Give
Tuesday June 3, 1:45 pm ET
By Igor Greenwald
SmartMoney.com
WITH A DEAL this good, there's always a catch.
I'm in the process of exercising my soon-to-be constitutional right to cheap credit by refinancing a home purchased eight months ago. The 30-year fixed mortgage I'd gratefully locked in way back in August is now more than a full percentage point above the prevailing rates, making the decision a slam dunk.
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For the cost of an appraisal and a token 6% increase in the monthly payment, I'm getting a 20-year mortgage to replace the original 30-year loan. My total borrowing costs are getting slashed almost exactly in half.
Here's the catch: Right after I finished my celebratory jig, I wondered what it says about the global economy that the cost of money is dropping so fast. All of a sudden, I didn't feel much like dancing.
Apparently, lots of people can think of no better long-term investment right now than lending to me at 5% per annum. Cisco Systems (NASDAQ:CSCO - News) shares might be up 28% this year, but its sales are not growing at all. Demand for capital is slack. Demand for a decent yield borders on the desperate.
I suppose I could have lowered my monthly house payments and invested the savings in rallying stocks. But I expect that Cisco's cheap broadband routers for home-office use will help real estate prices in my neck of the woods a lot more than they will benefit Cisco's margins.
This spring's concurrent stock and bond rallies have been nothing short of a freak of nature, the financial equivalent of a snowstorm in July. The simplistic explanation is that the stock market sees an economic rebound ahead, while bond buyers do not. But the fast money playing both tables is betting mostly on a steady stream of new chips from the none-too-invisible hand of Alan Greenspan.
The Federal Reserve chairman has pulled off quite a coup. He's made sure that you don't need to believe in faster economic growth to buy stocks, or in a perpetual crawl to own bonds. You can look it up: Any time a central bank worries aloud that inflation might be running too low, people tend to rush into financial instruments said central bank cannot devalue at will. The Fed is reflating, and anticipation of a rising electronic tide of dollars is driving up the price of all available alternatives, from euros and yen to stocks, bonds and gold.
In effect, the Fed has signaled to the financial markets that it will do whatever it takes to revive "normal" growth — that is, something considerably perkier than the 2.1% the U.S. economy has managed in the 12 months through March. "Whatever it takes" is commonly believed to mean at least one more cut in the benchmark federal-funds rate, which is already down to 1.25% and is expected by the people who trade such probabilities to get a haircut to 1% sometime this summer.
There might be room to cut it to 0.75% without squashing the mutual fund industry, speculates Merrill Lynch economist Gerald Cohen in a recent report. But after that the Fed could wage a more direct assault on interest rates by buying U.S. government debt on the open market. And whether it started at the long or the short end of the yield curve, rates should quickly drop across the board to whatever target the deep-pocketed central bank cared to set.
Imagine the Fed buying vast quantities of a stock you own. Imagine it announcing one fine day that it would buy Cisco until it hit $30 a share. So now you understand why people have been clinging to the 10-year Treasury note's skinny yield all year long.
Would it really come to a bailout by the Fed? After all, recent surveys of business and consumer confidence have been looking up. It's worth noting, though, that it didn't cost anyone anything to express all that confidence anonymously. And if the optimism does give the economy a spur, you'd want to guard against a recovery like last year's, which proved temporary.
Cohen, who doesn't sound half as sanguine about the extended economic outlook as all those purchasing managers, thinks the Fed could go bond shopping late this year or early next if growth does not pick up and stay up.
As it happens, the Fed governor most closely associated with this "quantitative easing" scenario, Ben Bernanke, was speaking on Saturday in deflation-stricken Japan, suggesting that the country's central bank could break the economy's downward spiral by buying lots of government bonds.
Such a reflation would be all the more effective, he went on, if it were carried out in concert with an aggressive fiscal stimulus — presumably, not unlike the aggressive package of tax cuts Congress has just enacted. If I were the suspicious sort, I might think Bernanke was sending a message back home.
This sets up a crucial distinction between stocks and bonds. For stocks to keep rising in the medium term, the economy has to recover. For bonds to keep rising in the medium term, the Fed must merely try to help the economy recover. And the Fed has already made clear that it will err on the side of doing more, not less.
Would bonds take a hit if Wall Street convinced itself that the economy can right itself without the Fed's help? Absolutely. But as we cheer the sheer intestinal fortitude of traders who've bid up the Nasdaq 25% in less than three months, understand that the really serious money is riding out these interesting times in bonds, which stand to be reflation's most direct beneficiaries.
U.S. stocks are currently worth some $9.2 trillion according to the Wilshire 5000 index. But the value of traded public and private debt, all of it benchmarked to Treasury yields, stood at $20.6 trillion by the end of March, according to the Bond Market Association.
And while the comatose IPO market produced nary an equity offering during the first three months of the year, the debt market swelled by a startling $464 billion over the same span, with homebuyers, corporate borrowers and the Treasury all finding willing lenders at dirt-cheap rates.
You've got to wonder whether the income needed to service all that new debt will be there if growth doesn't pick up, and soon. So I'm especially glad to know that the Fed has all the angles covered. |
