Eric Roseman's Eruptions: Stocks, Global Markets and Commodities BLOG

Are Treasury Bonds a Buy?

Amazing how the tables can turn so quickly in a span of just six months…

In 2008, Treasury bonds were the only fixed income category to post a profit amid total market chaos as investors shunned riskier debt. In 2009, Treasury bonds are the only fixed income sector in the loss column while riskier bonds have skyrocketed in value.

In 2009, benchmark ten-year T-bonds are down 2.6%, including interest income while 30-year T-bonds have plunged 15% -- their worst calendar year of performance since 1994.

Back in December the yield on the benchmark ten-year U.S. Treasury bond yielded 2.25% -- the lowest effective yield since the mid-1950s. Driven sharply lower by deflation fears, bank insolvencies and the rush to liquidity, investors drove yields down to absurdly low levels.

But starting in January the trend in Treasury bond prices had already shifted to a gradual ratcheting in interest rate premiums on expectations the Treasury would flood the system with record bond auctions. And flood the system it did; in 2009, Treasury is projected to issue a cumulative $2 trillion dollars’ worth of Treasury securities. With the exception of short-term bonds, Treasury is struggling to sell the longer end of the yield curve as inflation and supply fears mount.

The ten-year benchmark is important because it sets the tone for mortgage rates and consumer loans – something the Fed is trying to wrestle to lower levels to boost mortgage financing and consumer installment debt.

What’s even more alarming about this bear market in longer dated T-bonds is the fact the Federal Reserve has failed to influence long-term rates despite spending more than $125 billion dollars’ worth of Treasury bonds this year.

In other words, Bernanke is losing control of the yield curve, or the difference between short-term and long-term interest rates. That’s an important relationship because the economy is still deflating, loan growth is anemic and domestic consumption is barely growing since last fall. Yet the market is growing increasingly tired of the flood in Treasury issuance and still driving long rates higher. This is a bad sign for the economy, the Fed and consumption. The economy can’t handle higher rates, particularly in the mortgage area.

But if the economy is expected to post a sluggish recovery later this year then maybe Treasury bonds are a good speculation at these bombed-out levels. Benchmark ten-year T-bonds start looking attractive again north of 4%, especially if the economy posts another contraction in 2010 following the exhaustion of Obama’s $787 billion dollar stimulus plan – now hitting the real economy.

It’s pretty hard to make a strong case for a sustainable corporate earnings recovery in this environment because these are truly uncertain times. The consumer is finally out of the game, focusing on frugality, rebuilding his savings and certainly not looking to take on more debt. And the government cannot continue legislating spending packages without inviting some serious inflationary consequences.

In the absence of organic domestic consumption supported by rising employment – which is not the case now – just how is consumer spending supposed to meaningfully improve?

U.S. Treasury bonds and German bunds have both been mauled over the last four weeks. Yet I suspect these securities will offer some of the best and safest returns later in 2009 or 2010 as the global economy heads back into the gutter, starved for a new round of stimulus spending.

Bonds anyone?

Non-Treasury Bonds Beat Stocks in 2009 as Spreads Narrow

After suffering their worst year in decades in 2008, the entire gamut of speculative and investment grade bonds have posted big gains since the March 9 intermittent bear market low.

Credit spreads or the yield differential between benchmark U.S. ten-year Treasury bonds and speculative debt has crashed over the last eight weeks as risk returns to the fixed-income market. Spreads for investment grade bonds have also narrowed sharply – led mainly by a huge compression in bank-issued bonds.

In 2009, the S&P 500 Index is basically unchanged while the Barclays Aggregate Bond Index (includes all bond categories) has risen 1.4%.

U.S. investment grade corporate bonds, as measured by the Barclays Capital Corporate Bond Index, have gained 3.5% in 2009. Mortgage-backed bonds (Fannie, Freddie, Ginnie Mae) have climbed 3%. Municipal bonds have also enjoyed big gains with a 5.8% rally. The best-performing fixed-income category, however, belongs to high-yield or junk bonds, up 21.3%.

And as risk returns to the markets this spring investors are dumping Treasury bonds – clobbered since April. Intermediate-term Treasury bonds are down 2.4% this year while long-term bonds – the most sensitive segment of the yield curve to interest rate expectations – have plunged 11.6%. Treasury bonds are suffering their worst year since 1994.

For the first time since the start of the credit crisis my fixed-income indicators have now turned bullish. Though several important hurdles remain for a complete credit healing to occur, critically important short-term credit spreads have dramatically improved since March.

The short-term credit spread segment has rallied sharply since April with the TED Spread heavily compressing and now trading below 1%. The same is true for 90-day LIBOR or overnight dollar rates in Europe, which are responsible for setting more than $300 trillion dollars’ worth of global loans and funding requirements. LIBOR fell below 1% last week and is trading at just 0.85% this morning; LIBOR peaked at 4.82% last October.

To be sure, the riskiest segments of credit are now extremely overbought. Junk bonds, literally a trap for speculative investors as default rates continue to rise this year, have now gained more than 20% since late March. I continue to recommend avoiding the junk or high-yield sector as defaults have more than doubled since Q4 2008.

Risks, however, remain.

Several important credit markets have not shown the ability to trade without the Fed’s assistance. Banks that have raised capital without FDIC guarantees recently are still paying big premiums to raise financing. Also, the important mortgage-backed market is now witnessing a spike in rates – bearish for housing and refinancing activity. The Fed has already committed more than $300 billion dollars to mortgage-backed securities since November and is losing control of the fight to keep mortgage rates low. Though the current spike isn’t large, the trend is running in the opposite direction of the Fed’s target -- critically important since it affects consumer loans.

Another segment of the yield curve in trouble is the intermediate to long-term Treasury bond market. Interest rates have risen sharply since late March on the heels of “green shoots” appearing in the U.S. economy, rising inflation concerns and a recent poor auction of 30-year Treasury bonds last week. U.S. Treasury supply is estimated at $2 trillion dollars in 2009 – more than the combined issuance from 2006 to 2008.



With global capital markets now drunk with gains since March now is not the time to lunge after risk. This also applies to bonds, especially junk bonds. My focus this summer is to keep liquidity high ahead of another correction. Ironically, despite a deluge of issuance ahead of us over the next 12-18 months in the United States and Europe, government debt at the short end of the curve looks attractive. This is especially true if stocks correct this summer; investors are barely compensated in 90-day T-bills but can get about 1% on a two-year note, which trades just below par.

Stocks and speculative grade bonds have come a long way since March. If you subscribe to the view that this is a bear market rally then avoid chasing the short-term trend. The fundamentals for sustainable long-term domestic consumption in the United States remains bearish as the savings rate continues to rise while virtually every industry forfeits raising prices this year amid a deflationary environment. Don’t chase risk at these levels.

Have a good weekend. See you on Monday.

Odds of Sovereign Default Remains High in 2009-2010

The worst of the global financial crisis has passed. But the next leg of this severe recession has yet to cripple the weakest balance sheets among sovereign nations.

Before 2010 is over, possibly sooner, some countries in the Baltics, Balkans, Eastern Europe and Central America will join the list of battered credits that have reneged or defaulted on their foreign debt obligations. It’s hard, if not impossible, to imagine that we won’t witness a major sovereign government debt default in the course of this economic cycle.

As governments worldwide continue to pile on massive amounts of debt to fund an economic expansion amid the worst credit deflation in 75 years, the odds are growing that one or more sovereign nations will default on their foreign debt. Many countries, even mighty Germany have struggled to raise international funds to plug their budget gaps; since last October Germany has scrapped or reduced the size of four bond auctions.

If Germany and other core euro zone nations are struggling to raise funds then imagine what lies ahead for weaker sovereign credits?

Candidates for default include Latvia, Lithuania, Estonia, Romania, Ukraine, Kazakhstan, Hungary and possibly several other emerging market countries. It is also possible, though unlikely, that Italy or Greece might default. Even Ireland, virtually bust, is a potential candidate.



As the next phase of this crisis turns into an acute and deep recession, governments will come under pressure to spend even more money to rescue joblessness and growing economic discontent. As this next round of spending develops later next year or in early 2011, several nations will come close to the brink of default as finances become too stretched.

Already since last year Ecuador has defaulted while pressure on several other nations grows by the day. These countries are struggling to raise international funds to secure budgetary needs and in all likelihood will default. The IMF, or International Monetary Fund, will not be able to avert every funding squeeze; it’s lunacy for the IMF to hand out money to a nation just so that it may avoid a default. This is what happened in Ukraine and Iceland among many other nations over the last six months. How long can this strategy work effectively if economic conditions relapse later in 2010 once this round of fiscal spending draws to a conclusion?

Credit spreads or the difference between benchmark government bonds in the United States and Germany compared to weaker national bond markets in places like Ukraine and Greece continue to show stress. These spreads have not declined significantly over the last 60 days as equities and other capital markets have rallied.

Also, Latin America, which has largely escaped this credit crisis (except Argentina, which remains an economic lost cause) might take a turn for the worst if commodities prices resume their downtrend. One could make a case that a currency and debt “bubble” is now in play in Brazil – the largest economy in the region. The real currency has skyrocketed since 2003 while interest rates have collapsed. Does Brazil really deserve to be investment grade? The BOVESPA stock index trades north of 50,000 – not exactly a bargain, either.

In all likelihood it seems quite plausible that one or more sovereign borrowers will default before this crisis finally concludes. Germany will probably bail-out core Europe. But it’s up to the IMF to tackle peripheral emerging European nations if they default. The IMF can’t rescue everybody if a string of defaults begins to unfold like dominos. The chain reaction will be too violent.

Avoid emerging market debt. Credit spreads have now rallied to just 488 basis points or 4.88% above ten-year U.S. Treasury bonds. That is not reflective of the upcoming challenges affecting emerging market debt and the enormous task faced by an overwhelmed IMF.

Treasury Bonds Post Worst Losses Since 1994

Despite the Federal Reserve’s aggressive moves to purchase or monetize billions of dollars in Treasury supply this year, prices continue to roll over. Treasury’s are in the midst of their worst year of performance since 1994 when the Fed began raising interest rates.

This time, the Fed is not hiking rates. Instead, it’s attempting to keep a lid on rising long-term rates by purchasing the mid to long-term yield curve in a bold attempt to influence important mortgage rates and other consumer loans. Thus far this effort is failing.

The yield on the benchmark ten-year T-bond has climbed from barely 2% at the end of December to 3.36% this morning. The 30-year T-bond has been the hardest hit this spring with yields soaring from about 3% in late December to 4.31%. Earlier this year, the Sovereign Society Portfolio initiated a trade betting against long-term Treasury bonds vis-à-vis an ETF; that position is up more than 20% since late March.



The Fed, of course, faces tremendous headwinds, possibly a gale force in its attempt to keep rates stable.

Treasury issuance this year is estimated to surpass $1.2 trillion dollars while possibly reaching $2 trillion in 2010. There’s just too much supply hitting the market and investors are demanding higher interest rates.

Making the Fed’s task even more daunting is the stunning recovery in capital markets since early March as investors dump Treasury bonds en masse to assume more risk in stocks, speculative bonds and foreign currencies. This event has put significant pressure on the entire U.S. yield curve, especially longer term rates, which the Fed cannot control.

As I mentioned yesterday, sharply higher mid to long-term interest rates might take the air out of this short-term economic recovery – largely financed by government spending. The rapid increase of longer term interest rates now poses serious risks to any recovery.

Though I’m certainly bearish on Treasury bonds, especially long-term T-bonds, I’m starting to consider short-term Treasury paper up to five years. This segment of the yield curve offers yields up to 2.16% and selling around $98, or a modest 2% discount to par. Six months ago prices were rich and yields barely 1.5%.

In a world that’s gone hog-crazy for risk following the worst crash since 1937, I find myself hunting for conservative investments that pay regular dividends or income. The big decline in Treasury bonds should be viewed as an opportunity to park some money ahead of the next shock later this summer or fall. In that event, yields will come crashing down again and T-bonds will rally.

A heavily leveraged economy that’s still in the process of unwinding credit and toxic securities now faces a serious threat from rapidly rising longer term interest rates. This is not a normal bear market. Sharply higher rates are now in the process of derailing this fragile bear market bounce.

Have a good weekend. See you on Monday.

Credit Thaw Spreads to Junk Bonds, but Default Rates still Rising Sharply

Credit markets continue to improve since March with every segment of the fixed income curve enjoying an impressive rally or a compression of yields. At first, most credit spreads failed to join the broader rally in stocks off the March 9 lows. But now the entire gang has showed up at the party, including junk bonds, high quality corporate bonds, mortgage-backed securities, emerging market debt and even some leveraged loans. Only Treasury bonds are in the loss column this year following a stellar 2008.

Also bullish is the trend in short-term credit markets where 90-day LIBOR rates have sunk below 1% this week to 0.99% -- the first time they’ve traded below 1% since the advent of the credit crisis in late 2007.

But the biggest gains lie in junk bonds lately. Just two months ago, dealers couldn’t give away a junk bond issue; but since late April several new deals have hit the pipeline as investors assume more risk.



The spread or difference between ten-year Treasury bonds and the Merrill Lynch High Yield 100 Index has shrunk to just 671 basis points, or 6.71%, from a high of almost 14% last fall. Merrill Lynch still publishes several high yield indices but the most widely followed, the High Yield 100 Index, now yields 9.87% compared to 17.03% last October. Over the last four weeks, yields have crashed.

In April, several deals were financed in the junk bonds (high yield) arena that couldn’t get a bid back in February. Combined with significantly lower yields, junk bonds have already gained 12.6% in the second quarter.

Still, despite the hoopla, investors should avoid buying this riskier segment of credit now and focus on safer investment grade bonds and TIPS. Even short-term Treasury bonds look attractive at these levels to supplement puny money-market yields following a ratcheting of short-term rates since late March.

In all probability, this is a bear market rally – similar to the November to January rally.

There is a looming default cycle that has yet to be fully discounted by the market; default rates stand at just under 6% now compared to at least 10% or more in previous recessions. The market has incorrectly discounted the worst at this stage of the economic cycle because this remains a deep-rooted credit deflation. Default rates are likely to top north of 15% before it’s safe to aggressively accumulate junk or high-yield bonds.

Meanwhile, riskier bonds and stocks have come a long way since reaching the edges of the abyss in early March. I reckon we’re severely overbought at these levels and a new round of profit-taking lies ahead this spring or summer. Keep most of your powder dry.

Surge in Bond Yields Bad News for Fed

U.S. Treasury bonds continue to get pounded this quarter following their steepest losses since the Federal Reserve started raising interest rates in 2004. And, despite Treasury purchases by the Fed to contain a rising yield curve, intermediate and long-term bond prices continue to decline sharply.

In 2009, long-term government bond prices have plunged 10.3%, according to the Barclays Long-Term Total Return Price Index.

Meanwhile, investment grade and speculative bond issues are posting strong rallies over the last eight weeks as yields decline. Yet this rally is occurring at the expense of T-bonds as investors lunge after risk again.



As long-term rates continue to rise, mortgage rates have also begun to edge higher – a segment of the credit market the Fed is trying to aggressively influence through mortgage agency debt purchases since last November.

The S&P 500 Index or the U.S. broader market has now surged more than 30% since its last intermittent low on March 9. Soaring equity values are pressuring bonds as investors dump fixed income securities in favor of stocks amid the perception that global economic growth will recover over the next six months following the worst bear market for stocks in 2008 since 1937.

Rising interest rates now pose another challenge for the Fed. As stocks rally investors are forcing longer term rates higher, jeopardizing any sustainable recovery as consumer rates and mortgage rates climb. Will the Fed continue to aggressively purchase Treasury bonds even as the yield-curve rapidly steepens?

Though I’m certainly bearish longer term on Treasury bonds, especially longer dated securities in the wake of seemingly never-ending Treasury issuance and a massive inflation problem down the road, bonds are beginning to look attractive again as stocks hit positive territory in 2009 for the first time since 2007.

If equities are now overbought then government bonds might be undervalued over the near term as investor euphoria returns right at the wrong time.

Despite massive concerted global government stimulus spending, the case for sustainable long-term domestic consumption is poor in the face of soaring job losses, idle factory capacity output and, for the first time since 1955, a negative inflation rate. Companies do not have pricing power to sustain a meaningful earnings recovery – especially at a time when consumers in the United States are becoming frugal again and building their savings rates.

Maybe it’s time to buy smashed-out bonds again ahead of another correction in stock values this summer. Once again it would appear that investors are critically underestimating the collateral damage inflicted by this historical credit squeeze. Time will tell if this is indeed a new bull market or just another false rally in the context of a secular bear market.

Fed’s Attack on Short-Term Rates is Effective but other Segments of Credit Still Struggling

The Federal Reserve’s unorthodox policy response since the emergence of the credit crisis 19 months ago continues to bear fruit as credit spreads narrow. Though these and other measures are working to instill investor confidence, other important areas of the credit market remain hostage to illiquidity and historically high credit spreads that have failed to meaningfully narrow.

The Fed has aggressively engaged several segments of the once clogged credit system, including long-term mortgage agency debt and commercial paper. The central bank’s balance sheet expanded by $1.3 trillion dollars to $2.2 trillion dollars since August as the Fed purchased everything from corporate commercial paper to bonds backed by consumer payments on mortgages and car loans.



Some important short-term credit markets are definitely improving, including tightening credit spreads. These include LIBOR (London Inter-bank Offered Rate) and the TED Spread, or the difference between 90-day LIBOR and 90-day Treasury bills.

Another positive development since January is the widening yield curve, or the difference between two-year and ten-year Treasury bond yields. A widening yield curve portends to growing market expectations that economic growth is expanding thereby driving interest rates higher. In the first quarter, U.S. Treasury bonds suffered their worst three-month period since 2004.

Credit markets overall have rallied sharply since early March as stocks bottomed.

In addition to tighter or lower credit spreads across the entire spectrum of fixed-income benchmarks, corporate bond issuance has surged since January, including several deals for junk bonds, or high-yield debt.

Yet other problems linger on the Fed’s attack menu confirming the central banks’ limits on soothing or healing all fractured credit markets.

Despite lower credit spreads since March, the entire gamut of investment grade and speculative grade credit spreads remain historically elevated. Financing or refinancing for most companies remains difficult at best and even the most credit-worthy customers are paying historically high premiums above prime rates to secure funding. The credit crisis is indeed easing but by no means has it ended.

The only spreads that have returned somewhat close to pre-August 2007 levels is the 30-year mortgage rate area as the Fed has purchased more than $350 billion dollars of mortgage agency debt since last November. The bad news is that the Fed has started a chain of dependency whereby important segments of credit have grown accustomed to Fed or government purchases; once these operations cease it’s possible the market will force interest rates higher.

The Federal Reserve and Treasury have also started to monetize Treasury debt through a process called “quantitative easing” while also helping bruised states and municipalities through financial aid; the government now offers to pay up to a third of the interest or debt servicing for those states seeking government assistance or bailouts.

The Fed has done a good job helping to influence short-term credit markets and has injected desperate liquidity to clogged areas of borrowing and corporate financing.

Yet these bold initiatives alone won’t cure the credit crisis because too many other areas of the marketplace remain squeezed, including traditional sources of long-term lending to consumers (credit card), commercial and industrial real estate loans and auto loans. Default rates for these segments of busted credit are now at their highest levels in years and likely to get worse as unemployment continues to soar.

The war is being won at the short end of the borrowing curve but remains an ongoing battle at the long end of the marketplace, which is much more difficult for the government to control.

G-10 Bond “Bubble” to Bust Ahead of Economic Recovery

In their bold and desperate attempt to save the global financial system from collapse, the world’s largest industrialized economies continue to issue record levels of debt. And, as debt issuance hits the roof in 2009 and 2010, any hints of economic recovery are sure to rapidly deflate government bond markets as investors head for the exits.

The United States is set to issue about $2 trillion dollars’ worth of Treasury debt in the fiscal year that began last October – more than twice its previous level. Euro zone governments will issue about $1 trillion of debt in 2009 – an increase of 23% versus 2008. Either way you slice it these are spectacular levels of required funding and will ultimately put pressure on government coffers as the cost of absorbing all of this supply exceeds demand. Hence, “quantitative easing” to the rescue…

But what happens when the global economy manages a dead cat bounce once record levels of fiscal spending hits the real economy? Will central banks continue to absorb government paper the market doesn’t want to buy?

Economic growth implies rising price pressures as inflation escalates. Higher inflation or even the prospect of higher inflation is bad news for fixed income securities, especially government bonds in this economic cycle as the United States, England, Japan and the Euro zone all print massive amounts of money to bail out their battered and, in some cases, insolvent banking systems.



The best speculation over the next 24-36 months is betting against long-term government bond markets. In addition to death and taxes, I can’t think of a more pronounced certainty than rising government bond yields – except in the context of an outright depression or economic collapse.

Even with the Federal Reserve, Bank of England, Swiss National Bank and eventually the European Central Bank all buying their own paper (quantitative easing) the market will overwhelm these institutions if economic trends warrant higher bond yields.

For now, deflation, not inflation, is the primary threat to the financial system and capital markets as the United States and Great Britain recently reported negative CPI for the first time since 1955 and 1960, respectively in March. But at some point over the next 12-24 months, government bond markets are sure to implode if inflation begins to rise.

There is no better speculation than betting against government debt in 2010 and beyond.

I have zero faith that the Federal Reserve, The Bank of England and other central banks will be successful and timely enough to drain all of this monster sized liquidity from the financial system once the credit crisis stabilizes. History is on our side; inflation has nearly destroyed paper money since 1971 when Nixon broke the gold standard and this financial disaster will only ensure the death knell for fiat currency. No central bank can indefinitely control a market or an asset class; fundamentals will always overwhelm an institution, even the Fed.

Volatility Crashes but for How Long?

The big action in global markets since early March remains largely confined to trends in equities. As fears of an extended global market meltdown have receded since March, the VIX, or CBOE Volatility Index, or fear gauge, has collapsed a cumulative 28% since March 2.

Outside of stocks, barely anything is really moving at all, including government bonds, most corporate bonds, commodities and even currencies.

The lack of volatility in currency markets has been especially mysterious considering the relationship between the dollar and risk adversity since the onset of the credit crisis almost 20 months ago. As markets bled, investors dumped risky assets and piled into the dollar amid a wholesale liquidation of risk; the dollar has been rising only because institutions have been flooded with investor redemptions, which generated aggressive dollar accumulation.

The worst performing major currency, however, belongs to the Japanese yen, down over 14% since hitting an 11-year high earlier in March. The Japanese economy certainly doesn’t deserve a strong currency considering a whole range of economic data has literally crashed since January.

If risk is re-entering global markets then the U.S. dollar should be next on the firing line as investors move out of low-yielding Treasury bonds and sell dollars in the process. This should benefit hard assets, including oil and gold as investors once again seek to hedge their dollar assets from fears of rising inflation over the next 36 months.

Yet the U.S. Dollar Index (see below) is still hanging in there and remains above its important 200-day moving average but below its 50-day moving average. If the U.S. Dollar Index breaks below 81.70 then it’s quite probable the dollar will have peaked in the post-2007 credit crash.



Other assets, including crude oil – the largest single constituent in commodities indices – has also been confined to a trading range over the last few weeks. Crude oil has been unable to decisively break above $55 a barrel on this rally following a low of $33.87 earlier this year.

One of the most interesting market anomalies exist in the government bond market. Volatility has been markedly low even though investors have been selling Treasury bonds to buy stocks.

The United States, along with several other countries, is now heavily engaged in quantitative easing, which is basically a fancy term that equates to long-term inflation creation through debt monetization. Even though the Fed has been aggressively buying back Treasury debt over the last few weeks, yields on the entire range of Treasury debt has actually climbed, not declined.

If the Fed was not buying back Treasury debt over the last few weeks it’s highly probable that the entire Treasury yield curve would have steepened much further; hopes for an economic recovery – confirmed by the ongoing equity market rally since March 9 – should be accompanied by rising, not declining Treasury yields and therefore much higher volatility.

Volatility is now approaching an attractive level for speculators. The VIX can now be traded as an exchange-traded-note, or ETN, in the United States (symbols VXX and VXZ) while providing an easy route for investors to hedge their portfolio risk from the next correction. From its all-time high of 80.86 last fall, the VIX is now down 53%.

With the economy likely to be mired in a sluggish state over the next few years amid a deep credit deflation, investors would be wise to build some portfolio protection following a 30% gain for stocks since March.

Cash Management Crucial in Deflationary Market

Over the last several months I’ve touched on how to raise your cash management yield in an environment of super-low interest rates. Short-term rates are currently at their lowest levels since the 1950s causing a conundrum for income investors.

With money-market funds yielding about 0.5% and overseas dollar accounts paying barely 0.20% in annual interest, there’s certainly a better alternative to pitifully low or no yields.

Until the emergence of the credit crisis almost two years ago investors didn’t really concern themselves with cash management strategies. Interest rates on short-term bonds and money-market funds hovered north of 4% and the financial system was functioning. Offshore, a depositor could earn just under 5% in U.S. dollars and about 4% in euro.



Of course, the world has turned upside down since August 2007 and especially since the global crash last September and October. The Fed has sliced interest rates effectively to 0% and other central banks are not far from that target, including the European Central Bank. In almost every currency today investors are struggling to find a decent and safe yield to park their precious liquidity.

Deflation is the primary threat to the financial system as debt destruction spreads mainly to mature economy markets, threatening the viability of the banking system. Though most governments now stand behind their largest banks and will provide either blanket deposit coverage or full rescues in the event of a collapse, investors are rightly concerned about how to place their liquidity.

In the United States, investors can boost their effective yield by almost 100% by adding two-year Treasury bonds. These short-term notes have seen their respective yields rise from 0.76% on December 31 to 0.90% now. The two-year note is highly liquid, safe and, unlike a money-market fund, you won’t have to pay a management fee. Even better, short-term Treasury bonds now trade slightly below par, which guarantees you’ll lock-in your principle while making a small capital gain to boot even if bond prices decline further.

If you’re worried about inflation over the next 36 months – a real concern amid an avalanche of global government printing – consider a 5-year TIPS, or Treasury Inflation-Protected Securities. A five-year TIPS pays 0.92% plus any inflation over and above that rate. Instead of Treasury bonds beyond two years, TIPS offer far superior value than conventional Treasury securities because of the inflation protection.

If you’re offshore, boost your effective yield the same way by purchasing U.S. 2-year Treasury bonds or short-term bonds issued by the European Investment Bank (EIB), rated AAA. The EIB issues short and longer dated bonds in many major currencies.

Also, look at high quality short-term investment grade corporate bonds. Many of the biggest and safest non-financial sector bonds have already rallied since last fall and mostly trade above par value. But there are some exceptions.

For example, Nestlé, the world’s largest food company based in Switzerland, has a series of bonds denominated in major currencies, including dollars. The Nestle Holdings January 2013 bond pays an effective yield of about 2.5% or about 0.67% more than T-bonds. As far as I’m concerned, I have more faith in Nestlé’s cash-flow than most sovereign governments. Nestlé has gross revenues of more than $200 million every day.

Another interesting opportunity for cash management lies in the fixed-income securities issued by some of the world’s largest oil companies. Energy companies have huge cash reserves – many have more net cash than many governments! If you subscribe to the long-term view that Peak Oil will continue to pressure oil prices once this recession/depression concludes then bonds issued by these goliaths make good investment sense. Just be sure to keep your maturities under five years.

Finally, I also like short-term senior Canadian bank debt. The Canadian financial system is far stronger than most G10 countries since regulators didn’t allow mergers or takeovers and banks largely avoided crippling losses tied to mortgage-backed garbage. Not a single Canadian bank has been bailed out or received government assistance. Short-term high quality Canadian bank debt yields about 5% and most issues trade near or below par value.

To be sure, ultra-low interest rates suggest depositors will have to take some extra risk to capture higher coupons. There’s no FDIC deposit protection outside of the auspices of a bank savings account. Yet this strategy doesn’t have to be risky at all if you diversify your cash management portfolio across several sectors and maturities while sticking only to high quality investment-grade paper.