Just before landing, a plane encounters a phenomenon whereby the proximity of the ground creates increased air pressure beneath the wings. This “ground effect” makes it harder to bring the altitude to absolute zero, and pilots must reduce airspeed or change the angle of attack to further coax the plane down.
Monday morning, the S&P 500 was down about two percent and the 20-year treasuries were up about two percent. This has been pretty standard fare with the various “carry” trades and the suddenly very pronounced tradeoff between safe and risky assets. But as the yields on these long bonds now represent zero real interest rates (3% nominal), one would imagine that the “pure” tradeoff between risky stocks and “safe” treasuries with long maturities would become distorted as yields reach some “ground effect” point. In other words, if stocks were to fall thirty percent more, could 20-year treasuries rise thirty percent to create 2% yields? The answer is certainly that they could, given enough fear and substantially reduced inflation expectations.
However, with the kind of fear that would require, the prospects of a balanced budget or a reduction in the deficit become increasingly reduced, and this introduces more default risk could put some upward pressure on yields. It’s also hard to imagine a Fed that would not try to find some stimulus in the face of that implied deflationary threat.
What’s more interesting is how this would affect the dynamics of the trading and investing metric that is currently so well-defined. Would traders be more willing to sell something that resists rising, and would safe-haven investors be concerned that their investments have reached the worst possible risk/reward tradeoff: all risk and no reward? The need for a sensible reduction in high-flying leveraged trading is certainly a good topic for a later piece, but it bears consideration that the world’s capital might already be on the lookout for another, better, safe place to land.
Since the dawn of the digital age, US Treasuries hardly ever take physical form anymore. Since we can create them and transfer them using the lightest of particles, they belong in the category of things ethereal. As such perhaps they belong to the air.
If yields resist falling further, despite the application of mechanisms and convention, perhaps they are reaching the ultimate bottom—the ground.
