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