MARKET PLACE
Stock and Bond Markets Read Different Thermometers
By GRETCHEN MORGENSON
Is the financial crisis that first erupted in the global economy about two years ago really over? Or is there a lighted stick of dynamite somewhere out there just waiting to explode?
In the weeks leading to the meeting of Federal Reserve policy makers on June 30 -- a meeting that both stock and bond investors seem increasingly convinced will produce an increase in short-term interest rates -- the signals coming from the markets on the state of the world's economies could not be more mixed. While stock traders around the world exude confidence and find last fall's market meltdown just a hazy memory, the United States bond market remains fearful.
The worry is not only the traditional one -- that inflation is coming back to life. There is also a renewed foreboding that some yet-unidentified crisis looms on the horizon that will put an end to the belief that the fever that gripped much of the world is safely under control.
Because the nation's enormous debt markets are not as transparent as its stock markets, assaying bond investors' overall mood is tricky. But strategists say the market for non-Treasury debt still suffers from a fairly severe lack of liquidity, the result of an unwillingness among large brokerage firms to risk capital in their trading of corporate bonds, mortgage-backed obligations, even Treasury issues that are not among the current benchmarks. Further, the risk premiums that investors demand from more speculative debt securities, which take the form of higher yields compared with those of Treasury securities with similar maturities, have been increasing in recent weeks.
Part of the rise in rates reflects fears that inflation may be returning. Yesterday, the yield on the 30-year Treasury bond -- just about the safest investment in the world -- closed at 6.02 percent, the highest close in over a year. But it is not just jitters about inflation that are rattling the bond market. In recent weeks, yields on high-grade and high-yield corporate bonds and even those on less-liquid Treasury bonds and notes, known as "off the run" issues, have increased significantly compared with the yields on the most heavily traded Treasury securities with comparable maturities.
This widening of spreads, referring to the difference between what, say, a junk bond with a 10-year maturity yields over a Treasury with the same due date, usually indicates that investors see something worrisome on the horizon that makes them more risk-averse.
Indeed, notes Stan Jonas, managing director of Fimat USA, a broker-dealer in New York that specializes in futures and derivatives, "off the run" Treasuries have risen against comparable benchmark issues to levels close to those seen last fall after Russia defaulted on its debts and the hedge fund Long-Term Capital Management teetered on the edge of collapse.
"There is an underbelly here," Jonas said. "Credit spreads started to widen out in the last four weeks. People are getting themselves set up for some real problems. The last time we saw these kinds of spreads was in the midst of the post-Russia market dislocations that Greenspan, when he bailed out Long-Term Capital, said were so necessary to address."
Which makes the widely anticipated move by the Fed to raise rates very intriguing. Traditionally, Alan Greenspan, the Federal Reserve chairman, has been wary of a market mood exceptionally averse to risk because it indicates that capital formation could easily be crimped. Indeed, at the height of the market meltdown last fall, when trading in more speculative bonds virtually ground to a halt, Greenspan pointed to the frozen market as one of the key reasons the Fed felt impelled to lower rates three times in a two-month span by a quarter percentage point each time.
So, several analysts ask, if the bond market is not yet fully thawed and there is still little evidence of inflation on the scene, why does the Fed appear poised to raise rates? Of course, Fed policy makers have more than two weeks to change their views before the meeting at the end of the month. In the meantime, market watchers will be paying attention to see if Greenspan has anything to say about monetary policy in his speech today at the Harvard University commencement. And they will be even more intent on the Fed chairman's planned testimony to the Joint Economic Committee next Thursday, just one day after the Government releases data on consumer prices for May.
Some strategists wonder if Greenspan is capitalizing on a period of relative calm in international markets to raise rates to curb the runaway American stock market. If so, he may be disappointed. For indomitable stock investors have shown a buoyancy that even the specter of a rate increase has not depressed. The Dow Jones industrial average closed yesterday at 10,690.29, just 3.7 percent below its May 13 peak of 11,107.
Indeed, a rate increase by the Fed is now viewed by many equity investors as solid-gold proof that the world economic crisis has abated and stocks can be bought aggressively. This, even though higher bond yields are certain to draw some investor funds out of the stock market.
When the Fed announced on May 18 that it was shifting its stance from neutral on interest rates to leaning toward raising rates, it said, "Domestic financial markets have recovered and foreign economic prospects have improved since the easing of monetary policy last fall."
Recent rebounds in equity markets around the world -- particularly in previously depressed parts of the Pacific Rim and Latin America -- are taken as evidence that investors have seen the depths of the decline that began two years ago when the Thai baht was devalued. But dispatches from the bond market tell a very different story. For example, according to Salomon Smith Barney, last fall junk bonds yielded a staggering 6.64 percentage points more than did comparable Treasuries, up from a premium of 3.6 percentage points in January 1998. In early May, yields on junk had fallen back to 4.71 percentage points more than those on Treasuries. But they crept back up to a premium of 4.84 percentage points at the end of the month.
Bond investors, of course, are worriers by nature, while stock players thumb their noses at risk. But movements in spreads are watched closely because they reflect the willingness of bond investors to take risk. When times are good, spreads narrow, as investors exit the safest investments for the higher yields that riskier issues offer. Conversely, wider spreads are an indication that investors are increasingly afraid. Wider spreads are often a precursor to market turmoil. For instance, weeks before Russia defaulted on its debt last August, sending American financial markets into a tailspin, spreads on non-Treasury debt had been inching up.
The situation today is not as bad as last fall, but it has made many big brokerage houses wary of committing themselves to a position. "Dealers still seem to be constrained," said Martin S. Fridson, chief high-yield strategist at Merrill Lynch & Company. "Unless by a miracle, a buyer and seller steps into the marketplace with the same amount of bonds at the same price, dealers won't step in."
One piece of evidence that spooked bond investors recently was the Fed's May 1999 report on bank lending practices in the United States, made public on June 4. This survey of senior loan officers at 60 American banks showed that a greater share of banks had chosen to be more restrictive in their lending policies in the previous three months than had done so in the three months leading up to the January 1999 survey, a period that included the credit market turmoil of the fall. Why, they wondered, were more banks tightening their lending policies in what is supposed to be a healthy economy?
A rising default rate among speculative-grade corporate issuers certainly does not help. Twenty-three issuers defaulted on $3.4 billion in debt in May, bringing the default rate on corporate debt tracked by Moody's Investors Service to 4.3 percent for the month on a trailing 12-month basis, up from 4.1 percent in April. A year earlier, the rate was 2.72 percent; the average over the long term is 3.2 percent.
There has also been a fairly crowded calendar of bond issues coming to market recently as issuers try to raise money now in case of further interest rate increases later this year. Yesterday, Freddie Mac, Bank of America and Marsh & McLennan led $9 billion of corporate debt sales. This supply, and that in the pipeline, weighs heavily on the market.
Notwithstanding the Fed's sanguine outlook for foreign economies, many bond watchers fret that many wild cards remain overseas. Despite its rallying stock market, Japan still seems gripped by a deflationary spiral. Threats of a devaluation in China also contribute to a sense of unease in the Pacific Rim. Meanwhile, Latin America, especially Brazil, remains fragile, as does Russia.
"I think it's inevitable that you'll get another Brazil, another Russia, particularly with commodity prices weak," Fridson, the Merrill Lynch strategist, said. "I'm just sort of resigned to those situations continuing to come along periodically because I don't see any fixes that have been done."