Market Volatility and the Flight to Quality

When fear grips investors and money flows out of the stock market, it flows into the Treasury Bond market in a flight to quality. The result is higher prices for Treasury debt and therefore lower interest rates. If investors are anticipating higher interest rates in the near future, investments will be in Treasury Bills and other short-dated government or highly rated debt, but not longer term bonds. The scenario now is more about fear than greed; it is a flight to quality, not an attempt to garner higher interest yields. Evidence of this can be found in the recent auction results for the 10 year Treasury notes held August 10th where the issue resulted in the lowest interest rate for 10 year Treasury debt ever. This despite Standard and Poor’s recent rating downgrade of US Government debt.

This does not always result in a lower cost of debt for corporations, however. In the current situation, it is the willingness of the Federal Reserve to purchase longer term debt (quantitative easing), creating demand for longer dated securities and thus increasing prices (and therefore decreasing interest rates) that has allowed corporate treasurers to take advantage of lower cost debt. Several companies have issued longer dated debt that effectively lowers their cost of capital and yet evidence points to many of these companies sitting on this cash hoard instead of investing it in productive capacity or research and development.

Without the consumer, executives will be loath to build capacity to meet demand that is non-existent. Without employment, the consumer will continue to closely monitor cash flow and severely restrict discretionary spending. We are caught in a downward spiral. Our elected officials are not helping. The volatility of the stock market is a symptom. To gain trust that a cure for this economic malaise is working, we’ll need to see consumer confidence increase, which is tied to employment and the other indicators listed by Yaso. The interconnectedness of all facets of the economy means every action has ripple effects, not just here in the United States, but globally as well.

So yes, the stock market’s gyrations are not directly tied to overall health of the individual corporations. And a lower cost of capital means more projects can be taken on which should result in increased profits. But until corporate managers begin to believe the consumer markets will reward them for making capital investments, business investment may be limited to maintenance and repair, not development and innovation. Add to that the latent fear of inflation somewhere in the future and corporate treasurers can rest easier knowing they will most likely be paying back today’s debt cheaper once inflation does enter the picture. We are indeed living in interesting times.