Treasurys are in a bubble

The yield on all U.S. Treasurys securities are at historic lows. The 3-year T-bill and the 1-year T-bill have both actually sported negative yields — meaning investors are paying the U.S. Governemnt to borrow money from them. This is the first time this has ever happened and suggests that the zero bound may not be a problem. What gives?

The conventional wisdom in the marketplace is two-fold. First, many believe that investors are fleeing to the safe haven of U.S. treasury bonds and away from risky assets as the financial crisis has created extreme volatility in riskier asset classes. It is also believed that treasury prices are being supported by future deflation expectations. With the price of oil and commodities collapsing and consumer demand weak, inflation has dropped precipitouly in most countries around the world, including the United States.

I have a different view. Treasurys are in a bubble.

In the wake of popped stock, housing and commodity bubbles, some see a fourth bubble building — in Treasury bonds. Unlike those bubbles, this one doesn’t have to end disastrously.

Treasury yields, which move inversely to prices, are at historic lows. Friday, the yield on the 10-year note fell to 2.47%, the lowest in Federal Reserve records going back to 1962 and well below the average of the past decade of about 4.7%.

Treasurys have been rare good investments in this awful year, returning 10% through November, according to Merrill Lynch chief North American economist David Rosenberg, a longtime bond bull. But even he recently told clients that Treasurys were “clearly heading into a bubble phase” and suggested there might be greener pastures in other fixed-income investments, such as debt backed by government-sponsored entities.

Meanwhile, the U.S. government may post a trillion-dollar budget deficit in the fiscal year ending in September and has pounding fiscal headaches looming far beyond that. Some key buyers of its debt, foreign central banks, are launching their own expensive stimulus packages and would seemingly have better uses for their cash.

And while the U.S. government’s access to cheap money helps its efforts to stimulate the economy, it also may crowd out other borrowers. Municipalities and companies with good credit histories are paying exorbitant rates to borrow, arguably extending the pain of the credit crunch.

“We have a remarkable situation in which a 30-year loan to the U.S. government with a taxable instrument pays you 3% and a loan to the state of Ohio pays you 5% tax-free,” said David Kotok, president of money-management firm Cumberland Advisors in Vineland, N.J.

Eventually, investors will demand a higher yield for Treasurys. It could happen when risk appetite returns, or if the cash the Fed is pumping into the economy sparks inflation. Some worry a snapback could be as brutal as the popping of any bubble, sending interest rates soaring and short-circuiting any economic recovery.

Edward here. This is precisely the problem. No one knows what will happen if and when the economy recovers. It seems reasonable to expect that when things do turn around, investors’ risk appetite will increase. They will look at the paltry returns on treasury securities and flee for riskier assets en masse.

To my mind, it is not deflation and a flight to quality which created this bubble to begin with. It is easy money in the form of ultra low interest rates at the Federal Reserve. Time and again, the Fed’s easy money has created bubbles: in emerging markets, in stocks, in housing, in commodities. Now it is Treasurys. This bubble is only enhanced by the fact that many investors are fleeing to Treasurys not mindful of the quality of the assets. Because investors need liquid investments to sell during the market volatility created by the credit crisis, they are fleeing to the most liquid investment out there: Treasurys. This is not a flight to quality, it is a flight to liquidity.

But, let’s not forget the currency risk either. China is very exposed to the U.S., being the largest holder of Treasury securities. Will they want to hold these if the Dollar becomes a weak currency again? That would mean massive losses for the Chinese central bank.

But Treasurys have long defied bubble warnings, which cropped up as early as February, when the 10-year note yielded just below 4%. At the time, inflation was rising. Now it is falling. And the economy has turned much uglier, justifying lower yields.

Meanwhile the Fed, which begins a two-day policy meeting on Monday, has been swapping Treasurys for riskier assets. It can reverse that trade to keep yields from soaring and derailing the economy again.

“There’s a big actor out there called the Fed that has a huge balance sheet that used to be all in Treasurys and now isn’t,” said Council on Foreign Relations economist Brad Setser.

The Fed would have other allies in that effort — particularly China, which has an interest in keeping U.S. borrowing costs low, if only because it wants to protect American demand for its exports. Foreign central banks may have contributed to a Treasury bubble in the first place, but they also can keep its bursting from being messy.

It remains to be seen when this bubble will burst. But, burst it will — despite what this article from the Wall Street Journal says. And when it does so, it will be very messy, indeed.

Treasurys Can Burst Bubble, Land Safely – WSJ

Related articles
One-month U.S. T-bill yield turns negative – Reuters
Treasury Bubble Talk Grows as U.S. Gets Free Money – Bloomberg
Treasurys bubble danger – FT Alphaville

  1. hbl says

    My definition of a bubble is when an asset class continues to gain based on momentum alone and the pool of greater fools is not exhausted. I’m surprised to see you label treasuries so definitively as a bubble. It’s quite possible that they will be the most rational investment for the next 5-15 years (i.e., with the highest return or lowest loss), if a global version of Japan’s “lost decade” were to play out! (Even Krugman is talking about that as a real possibility now). I imagine but may be wrong that Japanese government debt has been the best yen-denominated investment since 1990. I know that this is not a certain outcome but the probability seems high enough that “possible future bubble” seems more appropriate to me in describing treasuries.

    Perhaps your point is that prices of other assets already discount this outcome — but again, how can you be so certain in this assessment?

    1. Edward Harrison says

      @hbl, I completely understand the potential for treasurys to outperform much as JGBs did when Japan experienced deflation. However, I think a mania is forming in treasurys.

      My simple explanation is something I tend to post on at some point: I call it the two-standard deviations rule. Basically, when any tradeable assets reaches a point two standard deviations above trend a self-fulfilling mania seems to occur. It’s as if a tipping point is reached where the “random walk” is no longer in play. It is what I would call “non-independent errors.

      In plain English: when an asset goes up enough, everyone thinks it’s a sure thing and piles in. This bubble-like group think has already started to happen in treasurys.

      While a bubble can last for year: look at Japanese real estate or u.s. housing: it is still a bubble from the point when these non-independent errors start seeping in. The whole thing could collapse at any time — and, therefore, these are asset class to trade in at one’s own peril.

  2. hbl says

    I’m curious on what you base your assumption that “group think has already started to happen in treasuries” and your implication that most of the large movement in price has been based on performance chasing. Is that determination based primarily on your two standard deviations rule?

    The recent extreme gains in treasuries have happened in a very short time period that coincided exactly with CPI dramatically falling below expectations. My read on the situation (speculative only, so possibly very wrong) was that the majority of the move was large investors (pension funds, endowments, etc) realizing that the fundamentals weren’t what they thought — i.e., the threat is deflation not inflation. I say majority — of course there were some investors changing performance rather than perception of fundamentals.

    As an example of another bubble, the NASDAQ bubble didn’t spike in quite as short a period as a few weeks, nor did it coincide with a change in any fundamental measures of the economy (e.g., CPI) that people pay the most attention to.

    1. Edward Harrison says

      @hbl, you’re probably giving me too much credit regarding my assumptions — because I am not as concerned with the fundamentals when I see a 2-standard deviation move! I know that sounds a bit odd but here’s my thinking:

      I am suggesting that a move so large is ALWAYS a bubble irrespective of the underlying fundamentals for why it happened. An example would be the upturn in commodities this past year. I happen to think we are seeing peak oil. But did peak oil justify $147/barrel?

      So, I am making an a priori assumption without having tested the fundamentals as to inflation expectations, etc, etc.

      But, the evidence does point toward bubble: what are the yields on other government bonds? What are the yields on corporate bonds? Why are treasurys outyielding TIPS? Why have treasurys returned over 20% this year? Why the discrepancies? Is it inflation? Is it risk aversion?

      When you have to start asking yourself so many questions before you get into an asset class, you know it’s not cheap. The reason I make an a priori assumption is to avoid investing in manias and taking a loss. It’s just too good to be true.

  3. hbl says

    You may be entirely correct (and I was also in the ‘commodities are a bubble’ camp despite peak oil)… However, two more questions:

    1. Have Japanese government bonds moved two standard deviations in any period since 1990? (I don’t know…)

    2. Would you characterize them as a bubble bound to eventually burst messily? (Note Japanese government debt has tripled to 180% of GDP even while the savings rate has been declining, yet Japan’s government CDS spreads are lower the than US and many other countries!)

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