Depending on one's perspective, the Treasury Department's landmark decision yesterday to eliminate the 30-year bond was either a masterstroke or an act of desperation.
Certainly, few on Wall Street believe the
official version of the story: That the decision was made because government officials really believe huge budget surpluses will return, obviating the need for the 30-year.
As my colleague Justin Lahart
detailed, most market participants believe the decision to eliminate the 30-year bond was made because multiple
rate cuts had failed to lower long-term lending rates sufficiently enough to reignite the economy.
But whatever the government's motives (and whatever you think of them), the bottom line is that the gambit appears to have paid off, at least for now. Building on yesterday's monstrous rally, the price of the 30-year Treasury bond rose 1 3/32 today, its yield falling to 4.81%. The benchmark 10-year Treasury couldn't sustain its big early price gains, but still saw its yield dip to 4.23%.
Stocks also advanced today, with the
Dow Jones Industrial Average
up 2.1%, the
higher by 2.3% and the
up 3.3%. The move came despite news the National Association of Purchasing Management's index fell to its lowest level since February 1991.
One day does not a trend make, but the performance of equities today warrants an examination of the link between the elimination of the 30-year bond and the stock market's rally.
To Bill Fleckenstein, president of Fleckenstein Capital in Seattle, there is no link. The development is "a nonevent" for equities because the earnings calculations used in most valuation models are "wildly off," according to the famously bearish money manager.
Certainly, as Fleckenstein noted, developments other than the elimination of the 30-year could have accounted for the market's rise -- including speculation of a settlement between the Justice Department and market-cap heavyweight
, which rose 6.4%.
Nevertheless, valuation models used by many Wall Street participants seek to assess the "fair value" of equities relative to Treasury securities. Most incorporate the 10-year Treasury note's yield rather than the 30-year. But given the 10-year has rallied demonstrably the past two days, the decision to eliminate the 30-year has directly affected the attractiveness of equities -- or, at least, the perception thereof.
"The huge rally
the 10-year has experienced in the past couple of days has certainly impacted valuation," according to Thomas Van Leuven, a strategist at J.P. Morgan. "If the 10-year becomes the unrivaled long Treasury, there would be a step-up in demand for it," resulting in still higher prices and yet lower yields.
That, in turn, would suggest equities are more attractive: Using a target of 4.50% for the 10-year yield, J.P. Morgan has estimated 1100 as fair value for the S&P 500 for year-end 2002. But a 10-year yield of 4.25% brings the fair value for stocks to 1160, he said.
However, Van Leuven said the firm is not yet adjusting its target for the S&P 500.
"We're not moving away from 4.50%" as a target for the 10-year's yield, he said. "We'll probably wait and see how it calms down a little bit."
Given that J.P. Morgan's market strategist Douglas Cliggott has become the poster boy for prudent equity analysis (and issued another dour outlook on
this afternoon), it's probably not surprising the firm isn't jumping the gun on revising its targets. Furthermore, many market participants are waiting to see whether the decline in yields is sustainable, or merely a function of short-term gyrations due to traders being caught wrong-footed by the Treasury's decision.
But "most people on the street who are using a discounted cash-flow model or dividend discount models are going to be raising their fair value targets, to the extent the elimination of the 30-year impacts the 10-year," according to Brett Gallagher, who oversees management of $3.5 billion as head of U.S. equities at Julius Baer Asset Management.
But Gallagher expects the positive implications for equities will be fleeting. First, he believes lower interest rates are an indication of the market's expectations for economic growth and inflation. Yet most market forecasters won't adjust their expected growth rates when recalibrating fair value based on lower 10-year yields. "I think their modes are going to give them an erroneous" reading, he said.
Second, as lower rates provide a stimulus to the economy -- mainly because of mortgage refinancings -- a "self-correcting" process will occur, bringing rates back up, the fund manager said.
Long term, then, Julius Baer hasn't changed its fair value assessment of 880 for the S&P 500. But, short term, Gallagher had been getting more optimistic about stocks; on Sept. 24, the firm reduced its cash from 15% to 5%, due to a view the market had become technically oversold and that "traditional" fund managers would be unable to stay on the sidelines.
Gallagher has since been rotating out of smaller, less-liquid names into bigger, more-liquid names such as
J.P. Morgan Chase
Bank of America
"It's uncreative but I think the index is going to be tough to beat for the next month or two," he said.
In terms of stocks directly influenced by the 30-year's cancellation, Goldman Sachs today cautioned that bank thrifts might be vulnerable because lower fixed rates would lessen demand for adjustable-rate mortgages.
fell 5.4% today.
Conversely, UBS Warburg raised its rating on Washington Mutual,
Golden West Financial
Golden State Bancorp
to strong buy from buy and
to strong buy from hold. Recent selling has put the stocks at historic low valuations, and the bond rally and resulting refinancing boom will be "modest and temporary negatives," UBS Warburg commented.
Elsewhere, firms involved in mortgages and related businesses were immediate beneficiaries of the 30-year's elimination. In addition to government-sponsored enterprises
, firms such as
Fidelity National Financial
had big gains today.