Stock and Bond Markets Read Different Thermometers
MARKET PLACE -- June 10, 1999
By GRETCHEN MORGENSON
As the financial crisis that first erupted in the global
economy about two years ago really over? Or is there a
lighted stick of dynamite somewhere out there just waiting to
explode?
In the weeks leading to the meeting of Federal Reserve
policy makers on June 30 -- a meeting that both stock and
bond investors seem increasingly convinced will produce an
increase in short-term interest rates -- the signals coming
from the markets on the state of the world's economies
could not be more mixed. While stock traders around the
world exude confidence and find last fall's market meltdown
just a hazy memory, the United States bond market remains
fearful.
The worry is not only the traditional one -- that inflation is
coming back to life. There is also a renewed foreboding that
some yet-unidentified crisis looms on the horizon that will
put an end to the belief that the fever that gripped much of
the world is safely under control.
Because the nation's enormous debt markets are not as
transparent as its stock markets, assaying bond investors'
overall mood is tricky. But strategists say the market for
non-Treasury debt still suffers from a fairly severe lack of
liquidity, the result of an unwillingness among large
brokerage firms to risk capital in their trading of corporate
bonds, mortgage-backed obligations, even Treasury issues
that are not among the current benchmarks. Further, the risk
premiums that investors demand from more speculative debt
securities, which take the form of higher yields compared
with those of Treasury securities with similar maturities,
have been increasing in recent weeks.
Part of the rise in rates reflects fears that inflation may be
returning. Yesterday, the yield on the 30-year Treasury bond
-- just about the safest investment in the world -- closed at
6.02 percent, the highest close in over a year. But it is not
just jitters about inflation that are rattling the bond market. In
recent weeks, yields on high-grade and high-yield corporate
bonds and even those on less-liquid Treasury bonds and
notes, known as "off the run" issues, have increased
significantly compared with the yields on the most heavily
traded Treasury securities with comparable maturities.
This widening of spreads, referring to the difference between
what, say, a junk bond with a 10-year maturity yields over a
Treasury with the same due date, usually indicates that
investors see something worrisome on the horizon that
makes them more risk-averse.
Indeed, notes Stan Jonas, managing director of Fimat USA,
a broker-dealer in New York that specializes in futures and
derivatives, "off the run" Treasuries have risen against
comparable benchmark issues to levels close to those seen
last fall after Russia defaulted on its debts and the hedge
fund Long-Term Capital Management teetered on the edge
of collapse.
"There is an underbelly here," Jonas said. "Credit spreads
started to widen out in the last four weeks. People are getting
themselves set up for some real problems. The last time we
saw these kinds of spreads was in the midst of the
post-Russia market dislocations that Greenspan, when he
bailed out Long-Term Capital, said were so necessary to
address."
Which makes the widely anticipated move by the Fed to
raise rates very intriguing. Traditionally, Alan Greenspan, the
Federal Reserve chairman, has been wary of a market mood
exceptionally averse to risk because it indicates that capital
formation could easily be crimped. Indeed, at the height of
the market meltdown last fall, when trading in more
speculative bonds virtually ground to a halt, Greenspan
pointed to the frozen market as one of the key reasons the
Fed felt impelled to lower rates three times in a two-month
span by a quarter percentage point each time.
So, several analysts ask, if the bond market is not yet fully
thawed and there is still little evidence of inflation on the
scene, why does the Fed appear poised to raise rates? Of
course, Fed policy makers have more than two weeks to
change their views before the meeting at the end of the
month. In the meantime, market watchers will be paying
attention to see if Greenspan has anything to say about
monetary policy in his speech today at the Harvard
University commencement. And they will be even more
intent on the Fed chairman's planned testimony to the Joint
Economic Committee next Thursday, just one day after the
Government releases data on consumer prices for May.
Some strategists wonder if Greenspan is capitalizing on a
period of relative calm in international markets to raise rates
to curb the runaway American stock market. If so, he may
be disappointed. For indomitable stock investors have shown
a buoyancy that even the specter of a rate increase has not
depressed. The Dow Jones industrial average closed
yesterday at 10,690.29, just 3.7 percent below its May 13
peak of 11,107.
Indeed, a rate increase by the Fed is now viewed by many
equity investors as solid-gold proof that the world economic
crisis has abated and stocks can be bought aggressively.
This, even though higher bond yields are certain to draw
some investor funds out of the stock market.
When the Fed announced on May 18 that it was shifting its
stance from neutral on interest rates to leaning toward raising
rates, it said, "Domestic financial markets have recovered
and foreign economic prospects have improved since the
easing of monetary policy last fall."
Recent rebounds in equity markets around the world --
particularly in previously depressed parts of the Pacific Rim
and Latin America -- are taken as evidence that investors
have seen the depths of the decline that began two years ago
when the Thai baht was devalued. But dispatches from the
bond market tell a very different story.
For example, according to Salomon Smith Barney, last fall
junk bonds yielded a staggering 6.64 percentage points more
than did comparable Treasuries, up from a premium of 3.6
percentage points in January 1998. In early May, yields on
junk had fallen back to 4.71 percentage points more than
those on Treasuries. But they crept back up to a premium of
4.84 percentage points at the end of the month.
Bond investors, of course, are worriers by nature, while
stock players thumb their noses at risk. But movements in
spreads are watched closely because they reflect the
willingness of bond investors to take risk. When times are
good, spreads narrow, as investors exit the safest
investments for the higher yields that riskier issues offer.
Conversely, wider spreads are an indication that investors
are increasingly afraid.
Wider spreads are often a precursor to market turmoil. For
instance, weeks before Russia defaulted on its debt last
August, sending American financial markets into a tailspin,
spreads on non-Treasury debt had been inching up.
The situation today is not as bad as last fall, but it has made
many big brokerage houses wary of committing themselves
to a position. "Dealers still seem to be constrained," said
Martin S. Fridson, chief high-yield strategist at Merrill Lynch
& Company. "Unless by a miracle, a buyer and seller steps
into the marketplace with the same amount of bonds at the
same price, dealers won't step in."
One piece of evidence that spooked bond investors recently
was the Fed's May 1999 report on bank lending practices in
the United States, made public on June 4. This survey of
senior loan officers at 60 American banks showed that a
greater share of banks had chosen to be more restrictive in
their lending policies in the previous three months than had
done so in the three months leading up to the January 1999
survey, a period that included the credit market turmoil of
the fall. Why, they wondered, were more banks tightening
their lending policies in what is supposed to be a healthy
economy?
A rising default rate among speculative-grade corporate
issuers certainly does not help. Twenty-three issuers
defaulted on $3.4 billion in debt in May, bringing the default
rate on corporate debt tracked by Moody's Investors Service
to 4.3 percent for the month on a trailing 12-month basis, up
from 4.1 percent in April. A year earlier, the rate was 2.72
percent; the average over the long term is 3.2 percent.
There has also been a fairly crowded calendar of bond issues
coming to market recently as issuers try to raise money now
in case of further interest rate increases later this year.
Yesterday, Freddie Mac, Bank of America and Marsh &
McLennan led $9 billion of corporate debt sales. This
supply, and that in the pipeline, weighs heavily on the
market.
Notwithstanding the Fed's sanguine outlook for foreign
economies, many bond watchers fret that many wild cards
remain overseas. Despite its rallying stock market, Japan still
seems gripped by a deflationary spiral. Threats of a
devaluation in China also contribute to a sense of unease in
the Pacific Rim. Meanwhile, Latin America, especially
Brazil, remains fragile, as does Russia.
"I think it's inevitable that you'll get another Brazil, another
Russia, particularly with commodity prices weak," Fridson,
the Merrill Lynch strategist, said. "I'm just sort of resigned to
those situations continuing to come along periodically
because I don't see any fixes that have been done."
Copyright 1999 The New York Times Company |
