If The Change In Our Pockets Isn't Enough

By: Michael Ashton | Mon, Jul 18, 2011
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I begin to wonder how much more 'flight to quality premium' there can be in U.S. Treasury bonds. Today Greek 10-year yields rose 59bps to match the old highs around 17.7%, Italian bonds rose 20bps to a new high of 5.95% (and the 10y BTPei real bonds +33bps to 4.13%), and Spanish bonds rose 25bps to a new high of 6.27%. The dollar rallied (a little), and equities dropped fairly sharply for a day with no news although indices recovered half of their losses by the close (S&P -0.8% and now down for the month after a torrid start).

And Treasuries? Unchanged.

TIPS rallied 3bps to 0.50% on the 10-year issue - I pointed out last week that weakness in Italy could perversely benefit TIPS and other ILB markets - but the real winners on the day were Precious Metals, +2.1%. Are precious metals becoming the new flight-to-quality (FTQ) instrument?

Please, gold bugs, don't plaster me with hyperventilated assertions that precious metals have always been "the" safe-haven instrument. They have always been "a" safe-haven instrument, but as they are less liquid than Treasuries and much more volatile, they have not traditionally been a flight-to-quality investment for institutional investors. Buying a billion dollars' worth of gold is not something you can do in ten minutes to hide out for the weekend, but you can do that in T-Bills. Actually, in T-Bills it will take you less than a minute.

Perhaps a more-nuanced answer (that will keep my house from getting egged by "the gold people") is that while precious metals are not a flight-to-quality instrument for normal crises, they do serve as a FTQ instrument for catastrophic crises, and while we have never really had one of those during the life of this republic, arguably our crises are starting to look less and less normal and more and more catastrophic.

But the simple answer to my hypothetical question is "no," for the reasons I have just given. But then, what is the FTQ investment these days?

It needs to be something with a stable value (preferably, stable in real space), and part of a deep and liquid market. This is why short-dated Treasuries have historically been the FTQ investment: the market is huge, you can buy and sell a whole lot of them very easily, and for short-dated maturities there isn't much price risk (because you're assured of par at maturity). TIPS would be better, because you'd be protected from inflation (albeit with a lag), but there aren't nearly enough short-dated TIPS to serve the function. T-Bills historically have tracked inflation with a lag and provided a small negative real return; in a crisis this isn't going to happen since the Fed will tend to clamp short rates at zero and intentionally produced a large negative real yield, but it's as good as it gets.

However, if the crisis involves the solvency of the U.S., then what?

We don't have to worry about that yet. T-Bills can trade (and have in fact traded) with negative nominal yields, so there's always a price at which you can buy some. But the reaction today in fixed-income land despite significant moves in some other markets suggests that investors who are buying Treasuries - especially longer Treasuries - for something otherthan a FTQ reason are already paying a not-insignificant FTQ premium to do so. There are other solutions, but this article is too small to contain them.¹

On Tuesday and Wednesday, the economic data is all about housing. Housing Starts are expected to rise (Consensus: 575k from 560k) as are Existing Home Sales (Consensus: 4.90mm from 4.81mm) but neither is at a level where we should care very much about the upside. Indeed, the recent rather-pathetic trajectory of Existing Home Sales suggests that downside surprises should be taken more seriously than upside surprises. But taking either measure is like taking the temperature of a cadaver and pronouncing, "Yep! Still dead!"

The main U.S. contribution to trading intrigue will actually come in the evenings. Kansas City Fed President Hoenig will be speaking on Tuesday night on "Monetary Policy and Agriculture." As a frequent-dissenter, his speech will be a decent indicator of how tight Chairman Bernanke has pulled the choke-collar with the new communications policy. On Wednesday the head of the NY Fed's Markets Group, Brian Sack, will be speaking to the Money Marketeers. That's the group before which, in December 2009, he delivered a great speech (which I discussed and excerpted here) about the effects of large-scale asset purchases on market rates that had one glaring error. I like to call it "Dr. Sack's Perpetual Motion Money Machine." Dr. Sack proposed ways to drain liquidity from the market when it was time to do so, and seemed to think that although the Fed pushed rates lower by buying securities (anyway, that was the whole point of it), they wouldn't push rates higher by selling securities. If that's true, then the Fed ought to do this constantly, in the largest size they can, because they can add tons of liquidity without any market cost and can drain it at will without ill effect. I discussed the perpetual motion machine here. There is another speech by Dr. Sack that I excerpt here.

Dr. Sack is unusually clear in his exposition, and worth listening to for several reasons. One is that you will usually get something pretty close to the party line; the other is that you'll probably learn something about how monetary policy works - or how the Fed thinks it works, which is even more useful.

However, I probably shouldn't beat up Dr. Sack too much, since I will be a presenter myself tomorrow evening (which is the reason I am mentioning Wednesday's data - I won't be posting tomorrow). I will be speaking at the NY QWAFAFEW meeting on the topic of "Quantitative Estimation of Inflation Perceptions." Let me know if you'd like me to come speak to your group about something exciting like that!


¹A reference to Pierre de Fermat's teasing theorem in the margins of a copy of Arithmetica. For a wonderful, entertaining, and easy-to-read book about Fermat's "Last Theorem," I heartily recommend Fermat's Enigma: The Epic Quest to Solve the World's Greatest Mathematical Problem.



Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA

Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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