By Brandon Humphryes, CFA
Senior Portfolio Analyst
It seems that we are all playing the waiting game these days. There is a staggering amount of cash sitting on the sidelines, just waiting to be thrown somewhere when the elevator music stops playing, and somebody finally picks up the phone. In a rate environment like ours, in which it seems like you might find more value depositing money in your couch cushions, it is difficult to remember that there is a value to every basis point you can muster.
Our Market Expectations
As the investing public, we’ve become prisoner to our own market expectations - nobody wants to get burned again, so we are all going to wait until the temperature is just right to jump in with both feet. Caution is both understandable and expected, but can also be paralyzing.
Take the two-year U.S. Treasury yields for instance (see chart below). For the better part of the last year, yields have settled in a range of 90-100 basis points (bps), or 0.90% and 1.00%. If you had timed your investment perfectly, you might have invested at 1.41%. That was available for one-day, before quickly beginning a decline back to the 90-100bps range less than a month later.
Why did this happen? In a market in which nobody can predict with any certainty, economic releases with surprising results can cause either panic (surprisingly negative) or euphoria (surprisingly positive). In a panicked state, the market rushes excess cash into Treasuries for safety, causing a squeeze on yields. In a euphoric state, the market rushes excess cash into equities, causing Treasury yields to spike. With the loads of excess cash sitting on the sideline, those euphoric spikes quickly evaporate, cash filtering in from those who don’t believe our economy is on the quick road to recovery. So yes, there are opportunities out there for those of you hoarding cash for a “rainy day”, but the odds are against you.
Good Days and Bad Days
Let’s look at it a bit closer. Out of 261 trading days in 2009, only 57 of them presented 2-year yields over 1.0%. That equals about 22%, or a 1 in 5 chance that you would have picked a “good” day to invest. The chance that you may have selected a “bad” day to invest in 2009, with 2-year yields lower than 0.90% was 33%, or a 1 in 3 chance. The average 2-year yield on the year was 0.94% nearly smack dab in the middle of that 90-100bps range so apparent throughout the year. You had a 45% chance of investing within that range in 2009 if you were a 2-year investor.
So why do I bring all this up? Well, for argument’s sake, let’s say you were trying to time the market and make one of those “good” investments. A 22% chance equals approximately 2.5 months out of the year. If you are waiting around to invest, the possibility exists that you are wasting that other 9.5 months. Of course, that would be an extreme case in which your investment opportunity comes at the end of a very long wait, but it reminds us that there is something to be earned, regardless of how little, in that potential down-time. A mentality that tomorrow will be the “good” day, may leave four days of “nothing” in its wake.
Predictions for 2010
Now, last year may have been an exception. The financial world was near collapse and any rate increases probably would have exacerbated the problem. As we look to 2010, the vast majority of us assume that rates will get better. Analysts predict it, economists predict it, editors and authors predict it. As the financial crisis showed us though, predictions can go terribly wrong. Predictions are made on the basis of events unfolding “as expected”. If you dissect our financial situation today, you will find a great many “as long as” or “ifs” involved in any scenario. The economy will improve if this happens, or as long as that happens. We are coming out of a time of unprecedented rate levels, unprecedented government involvement and unprecedented correlation within global markets. I’m fairly certain that nobody is altogether clear on exactly how this is all going to shake out in 2010.
In 2009 we were flying by the seat of our pants, tossing stuff against a wall to see what sticks. In 2010 we are hoping to clean up a little bit. So it is in this environment that I caution everyone assuming rate increases are imminent. It is possible that the housing sector struggles mightily as government intervention is scaled back. It’s possible that the workforce has become so productive that jobs will not return in full. It’s possible that we’ve become addicted to low-rates—our houses, cars, education and other borrowed items have become relatively less expensive over the past year. Are we as consumers going to accept higher prices in the form of higher rates now that we’ve embraced these levels? If we don’t accept it, what does that do to some of these already struggling industries? Does it portend of future scale-backs, additional layoffs, etc.?
Time for Unconventional Measures
That, of course, is the doomsday mentality, but highlights real risks involved in potential rate-hike decisions. The Federal Reserve has used unconventional measures to boost economic growth in this recession and they may use unconventional measures as a first defense in tightening economic policy. By this I infer that a rate-hike may not be their preferred option under these circumstances. They may start by using a combination of asset sales, reverse repurchase agreements and enabling Fed term deposits. The benefit of these tightening measures is that they are done behind the scenes, and might not have the same impact that outright rate hikes may have on stunting economic growth. The Fed is going to have to be aware of the public relations nightmare that may come about if it appears that employment momentum is halted as a result of their actions. This added pressure may push the rate-hike option a bit further back in line.
So I Should Do What Now?
Ultimately, you’ve got to be comfortable with your own investment decisions. I simply mention these potential pitfalls to remind us that we are in uncharted territory here. The smart money says that rate hikes appear likely in the third quarter, but the smart money also just cost us trillions of dollars over the last few years. If you can pick up some yield moving from cash to 2-month, 4-month, 6-month investments, it might make sense in a world in which rate hikes are no certainty and rates continue to oscillate within that band we saw throughout much of 2009. Alternatively, continue to enjoy the smooth styling’s of Kenny G. as you wait for the Fed to pick up the phone.
