Risk Neutral

The Wall Street Journal is reporting today that Treasury is considering issuing short term paper with negative yields. In a survey of its primary dealers, itfound that at least some of its dealers were willing.

The story is behind the pay wall, but the following is a direct quote:

“Negative-yield bidding is a great idea, and the Treasury Department should have considered this a few years ago,” said Scott Sherman, interest-rate strategist in New York at Credit Suisse Securities USA LLC, a primary dealer, who answered affirmatively to the question regarding the negative-yield bid question.

Just to make sure we are all on the same page here: a nominal negative yield security would give back less at maturity than what you paid for it. In practical terms, you would buy a 3 month T-bill that pays zero interest for $101 and get back $100 at maturity, thereby locking in a $1 loss.

My friend, the Sage Investor has argued forcefully that we are about to get hammered from too much debt. To quote:

The main theme behind social fears is the simple fact that there is an unsustainable, overwhelming amount of debt in the world. It is too many multiples of global GDP to be sustainable. The only way to correct this overshoot of credit is for the markets to collapse and reset. All asset prices will deflate when credit shrinks. Please keep in mind the following excerpt from a recent post. This concept is paramount.

And yet, here you have folks lining up to lend at a predetermined loss. How come?

I think the Sage is looking at debt a little too rationally. In a rational world, he is absolutely correct: too much debt MUST result in delevering and that inevitably leads to deflation. But I don’t think we are living in a rational world.

We are living in a world that accepts current cashflows for perfectly uncertain future payments.

Consider the ways in which we have made current cash flows more important than future recovery:

1. Mortgages used to be for 10 years. They then went to 15, 20, 30 and briefly during the mad days of 2002 – 2005, an incredible 40 years. What was that except an attempt to alter present cash flows by kicking the principal repayment can down the road?
2. Duration extension of the Barclay’s Index (formerly Lehman Index). Ten years ago, the duration of the index was about 4.25. Today it is out around 5.67 for corporates. Aside from technical factors, issuance has become more long dated
3. Presence of CDO and CDO squared and synthetics. These are products that serve no purpose other than to convert long term payment promise into short term cash flows.
4. The Greek Tragedy. This whole exercise has been to find a way to kick the Greek debt can down the road while saving face.

What this tells me is that the financial world is happy to push bond maturities out into the future in exchange for current cash.

But shouldn’t that mean the exact opposite: Shouldn’t people be demanding high rates of current return from the Treasury especially if they believed that Treasury default from too much debt was inevitable?

Logically, that should be the case. But as a practical matter we see that people are willing to lend to the US government with no expectation of return. That tells me that they are incredibly pessimistic about a recovery, at least in the short term. It also tells me that the market does not believe for an instant that the US Government would actually default. It also means that they expect the Stock and Bond markets to have a negative total return over the next three months.

So, I think the Sage is wrong – not on the logic, but his faith in the rationality of markets. I am comfortable in the argument that a world which thinks that Greece can get out of this with anything other than a clean default is a very irrational one.

That world is very capable of extending debt into the infinite future and pretending that things are A-OK and we will simply grow our way out of this with no deflation. By the time the 100 year bond comes up for maturity, I will be long dead, so why not?