Our Thoughts on the Recent Market Correction and the new U.S. Treasury "Floaters"

On Monday, January 20th the U.S. markets decreased roughly 1% in value, and European and Asian indices were down by similar amounts the following day. The S&P 500, which as a reminder is regarded by most as the best metric of large company U.S. stocks, then fell 2.1% on Friday, Jan 24th. This combination was enough to cause pundits and investors to ask whether we are now in the early stages of a bear market.

We continue to believe that nobody really knows--not the Fed economists, not the fund managers and certainly not the market pundits. A Wall Street Journal article noted that most of the sellers on Friday were short-term investors who were involved in program trading, selling baskets of stocks to protect themselves from short-term losses. Roughly translated, that means that a bunch of professional traders panicked when they learned that Chinese economic growth is slowing down on top of worries that the Fed is buying bonds at a somewhat less furious rate ($75 billion a month vs. $85 billion) than it was last year. Furthermore, we often wonder how the Wall Street Journal could possibly know whether “most of the sellers” were short term investors.

We maintain that it is often a mistake to sell into market downturns; these corrections happen more frequently than most of us realize. A lot of people might be surprised to be reminded that in the Summer of 2011, the markets pulled back by almost 20%--twice the traditional definition of a market correction--only to come roaring back and reward patient investors. There were corrections in the Spring of 2010 (16%) and the Spring of 2012 (10%). Indeed, most investors seem to mistakenly look back at the time since March of 2009 as one long largely-uninterrupted bull market.

Bigger picture, since 1945, the market has experienced 27 corrections of 10% or more, and 12 bear markets where U.S. equities lost at least 20% of their value. The average decline was 13.3% over the course of 71 trading days. Perhaps the only statistic that really matters is that after every one of these pullbacks, the markets returned to record new highs.

We may get a full 10% correction or even a full bearish period out of these negative trading days, and we may not. But the history lesson suggests an important theme/trend: the people who lose money in the long term are not those who endure a painful market downturn. Rather, those people who panic and sell when the market turns down usually do not have the conviction to re-invest, and thus miss out on the ensuing rally.

Floating Rate U.S. Treasury Securities

Separately, the U.S. government does not often innovate and provide new investment opportunities. On Wednesday, the U.S. will offer people what they've been asking for: a government-guaranteed bond that will give them floating interest rates. "Floating" means that the two-year security's interest rate will reset every day, based on movements in short-term interest rates. This is the government’s response to the prevalent fear that interest rates are going to go up sharply, causing bond values to crash. If interest rates go up, the new Treasury security will pay higher interest, and the value will remain constant. Of course, if they go down, which is always possible, then the security will pay lower interest--but, the value will be the same.

These "floaters," as bond traders are calling them, will offer the same return, each day, as the daily return that an investor in three-month T-bills would have gotten on an annualized basis during the most recent Treasury auction. Essentially, that means that people who buy a 2-year floater will get a yield comparable to what bonds with much shorter maturities are paying their investors. This is not normally considered to be a great deal. Currently, 3-month Treasuries are offering a 0.07% annualized rate, compared with 0.39% for bonds with 2-year maturities. Plus, you get the guarantee that if rates go up, so will the rate on your bond.

Is the guarantee worth the rate tradeoff? It may be helpful to know that the U.S. government essentially controls its own bond rates, since the Federal Reserve is still the biggest bidder in the government auctions, and since the Fed also sets short-term rates in the marketplace when it declares the rates at the reserve window where banks can borrow and park their dollars. The government doesn't have a great incentive to cause Treasury rates to rise dramatically--and, therefore, raise its own borrowing costs--just like you wouldn't voluntarily let companies charge more interest on your credit card debt. You should also know that as economies become healthy and robust--which is one goal of all these Fed Quantitative Easing (QE) interventions we keep reading about--the yield curve typically steepens, which means interest rates rise for 10-30 year bonds, but not so much (if at all) for short-term maturities.

Add this up, and you have a formula where the economy might recover gradually, and the Fed might lose a bit of control over the longer-maturity rates, which would rise and potentially hurt investors holding longer-term government bonds. Meanwhile, shorter-term rates might rise little if at all, giving the government a chance to borrow from floater investors for two years and pay them 3-month rates.

As an extreme example, imagine if short-term rates were to double and 3-month T-bonds were to start paying 0.14%. You would still be much better off owning 2-year bonds paying 0.39%. In fact, you would be better off owning (and holding to maturity) 2-year bonds if short-term rates were to go up 500%, to 0.35% a year.

The government seems to have learned an interesting lesson from Wall Street: when people are fearful, sell them safety at a very high mark-up.