Here's a Bloomberg screen showing the yield on 3-mo. T-bills since the beginning of last year. The world's favorite safe asset is now yielding close to ZERO (actually, 0.06%), and that yield has been declining for most of the year, despite the double-digit gains recorded by domestic and global stock markets, corporate bonds, industrial commodities, gold, and crude oil, and despite the strong fundamental backdrop of sharply lower swap spreads and implied volatility, and increased liquidity. With the Dow reaching 10,000 today, it is up 53% from its closing low last March, and the S&P 500 is up 61%.
In a post last December, I said:
It only makes sense to hold zero-interest cash if the prices of alternative investments continue to decline. If the economy doesn't continue to deteriorate significantly, then cash will prove to be a major embarrassment."It took a few months for the rally to get started, and we had to suffer through the awful February-early March collapse, but we're clearly witnessing one of the most spectacular rallies in Wall Street history.
With the underlying fundamentals (e.g., swap spreads, agency spreads, implied volatility, liquidity) improving, the economy is not likely, in my view, to deteriorate enough to keep the prices of other assets declining. Thus, as time passes, investors will be compelled to trade in their cash (or increase their borrowings, since borrowing costs will be extraordinarily low) in exchange for riskier assets. And that in turn will set off a virtuous cycle to the upside which could be rather spectacular.
The Fed helped get this rally going by ensuring that there was no shortage of money (another favorite theme of mine). Even though people have been terrified of depression and deflation, and even though people continue to be awfully worried about a double-dip recession, a collapse of the commercial real estate market, another wave of residential defaults, the deleveraging of the household sector, and/or a potential Fed tightening, there remains the fact that the Fed is keeping short-term interest rate extraordinarily low. To willingly hold cash that yields zero, you must be convinced that there is death and destruction awaiting at every turn. The market is climbing terrifying walls of worry, yet on the margin people are slowly being forced to reduce their money balances and increase their exposure to risk, and consumers are spending some of the cash they have hoarded, and it all adds up to a virtuous cycle that is giving us a V-shaped recovery. As long as the economy fails to deliver death and destruction, the market finds itself compelled to keep this virtuous cycle going.
The Fed should have started tightening awhile ago, but they are throwing caution to the wind in order to ensure a recovery. What the Fed wants, it can surely get. It may get more than it wants, in the form of asset price bubbles and higher inflation, but that remains to be seen. In the meantime, I don't see any signs that equities are overpriced (the Dow has only just returned to levels it first saw over 10 years ago) or that the market is overly confident (credit spreads are still very wide and implied volatility is still unusually high).