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Does Anything Look Good Right Now?

Moorad Choudhry, Head of Business Treasury, Global Banking HKSCKPVIamp; Markets, Royal Bank of Scotland
Wednesday, 19 Oct 2011 | 3:41 AM ET

Optimism has been a rare commodity in financial markets in 2011. However, institutional investors don’t have the luxury of being able to place their cash under the bed, although given that money market rates are at virtually zero in US dollars and sterling, and at negative real (after inflation) rates in both those currencies and euros, that is pretty much what placing funds on deposit is equivalent to at the moment.

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Pessimism about the state of the economy affects the corporate industrial sector too, but its response is generally to hold off on making capital investments and wait for the situation to improve. Institutional investors have to place their cash somewhere. But where exactly? A previous article in this column noted the dwindling range of genuinely risk-free assets, which poses its own problems, but with rates already at rock bottom, the yields on government bonds will only be rising over the long term. Investors looking outside the risk-free space aren’t confronted with that many healthy options.

An article on this subject in The Economist this week makes for grim reading. Its starting point is the premise, observable through history, that when yields are at absolute low levels, the subsequent return is low. In essence, what this means is that returns are lower over time when base rates are at 1 percent than when they are at 10 percent. This seemingly negative spiral can only be broken by positive economic growth of course. In the meantime, real returns are (according The Economist) set to remain low or negative across asset classes, be they equities, bonds, commoditiesor real estate. Even gold doesn’t get a look in. Given that gold will almost certainly start to fall back in price once US dollar rates start rising, this is understandable. That said, it would appear that US dollar rates won’t be rising until 2013, so still some time for gold to breach the $2000 per ounce barrier.

Having cast an eye over this space, it seems that inflation-linked government bonds look somewhat attractive. The Treasury yield curve is still positively sloping, with the 10-year benchmark yielding 2.12 percent. The curve would be inverted if the market expected the US economy to move back into recession , but whether it does or not, an inverted curve would produce negative forward rates and long-dated spot rates, which wouldn’t work for anything other than very short periods. So the curve stays positive.

Which means investors can lock in positive real yields while protecting against inflation . The spread between conventional sovereign bonds and inflation-indexed bonds gives an idea of the market expectations for inflation. The 10-year Treasury inflation-linked bond is implying inflation at around 3.7 percent, close to where it is now, which preserves a real yield of around 15 basis points.

Have we really reached such straightened times, where a real yield of a handful of basis points is something to write home about? The significant word there is “real”. US T-Bills are back to paying zero (literally; the three-month rate is 3 basis points) while some analysts expect equity index yields in 2012 of around 1 percent. After allowing for inflation, these are negative yields. Maintaining a positive real yield over the next 10 years is a challenge for investors whatever asset class they are in. Locking in a positive real return, however small, is still a better prospect than placing cash under the mattress.

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Moorad Choudhry is Head of Business Treasury, Global Banking & Markets, Royal Bank of Scotland, and Visiting Professor at London Metropolitan University.

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