Stephen Roach: “Rates can go to unusually low levels for much longer than people think”

With the global economy in recession and inflation headed toward zero, government bonds are looking like the best place to put one’s money.  As a result, we have seen yields on these assets drop to incredibly low levels in the world’s largest developed economies as their prices have increased.

I am on record for expecting this rally in government bonds to continue due to the economic environment despite having labeled Treasuries a bubble.  Stephen Roach agrees with that assessment, which brings me to his quote:

“Rates can go to unusually low levels for much longer than people think.”

That is exactly my point regarding Treasury securities. They may show all the hallmarks of a bubble. But does that mean that the bubble will end now? That did not happen after Greenspan’s irrational exuberance quip in 1996. It didn’t happen in 2004 and 2005 when the Federal Reserve and the Bank of England were looking to stem the tide of residential property price bubbles.

Certainly there are those like Marc Faber who think Treasuries will tank.

“It’s hard to believe that after blowing up so many bubbles over the past couple years, the Fed is managing to blow yet another bubble,” he says.

“Thirty-year Treasury bonds are yielding about 2.5 percent. You would have to assume that over the next 30 years there will be no inflation problem” to make those yields attractive.

Given the expansionary fiscal and monetary policy of the United States, “there will be a time when inflation accelerates along with a weak dollar,” Faber says.

“When that happens, central banks will have to increases interest rates, which will be difficult to implement.”

You should notice that Roach and Faber have similar views on the direction of the global economy over the next five to ten years, but drastically different views as to what this means for government bonds.

While I have my money on a rise in Treasury bonds, this is not a sure thing by any stretch. If the Federal Reserve reflates the U.S. (and the global economy) through massive stimulus, you can be sure that Treasuries will be in for a very nasty correction.

Roach: No Recovery Until 2010 – Newsmax
Faber: Recession Will Last Five to 10 Years – Newsmax
Faber: Short Treasuries Massively Now – Newsmaxi

  1. Stevie b. says

    Ed – not that I am one to argue with Roach for whom I have gargantuan respect, but I just don't see it on a risk/reward basis. If the long bond now yields a tad over 2 1/2 percent, how can it be prudent to invest now after all these years of declining rates for a possible last-gasp gain from rates that might by your own outside-the-box guesstimate go to 2 percent? Yes, the Fed may keep buying this stuff to manipulate rates lower along the curve via QE and yes maybe it would be a punt to buy now and then flog the stuff to the Fed. A rigged market with its inevitable implosion might just be a market in which to speculate, but it cannot be one in which to invest. My worry is that in fact there is little left in which to invest as everything seems rigged – including gold. Maybe new-issue TIPS are the answer – assuming that is that they are still being issued and not just re-opened, where I think there is a deflation risk that a new investor could lose the accumulated inflation built-in to the price since original issue?

    1. Edward Harrison says

      Stevie, the risk-reward is NOT good for betting on Treasuries. One could easily lose one's shirt on a fall in Treasuries as the downside far exceeds the upside. But, the Fed has skewed the incentive structure by lowering rates to zero. I think a lot of people will take the bait. If too many investors start seeking risk (i.e. in equities, high yield) then treasuries will blow up massively.

      While I think the Fed will be unsuccessful in reflating the economy and Treasuries will go higher as a result, I would not recommend the investment on a risk reward basis. So, I side with Roach but fear Faber's outcome. TIPS (or Gold) are looking like an interesting side-bet to hedge against that scenario

  2. John Creighton says

    Since I don't have money to invest, I'm going to posted the opposite argument here:

    I'd actually short the 30 year treasury and go long on the 10 year Municipal (Play the spread), cover my margin in gold, which will hopefully will yield interest at a bank where I can deposit gold and collect interest on it. Basicaly, since gold is the main store of value I'd want to keep my net capital in gold and use it as leverage to try to make money on the spread between the interest rates.

  3. Edward Harrison says

    The argument that Treasuries are a sucker's play is nothing I would disagree with. The question is whether they will continue to rise, not whether one should bet on that rise. In my view, I'd prefer to stay away from Treasuries as much as possible because the outcomes are too extreme and the uncertainty too great.. Sometimes the best investment is no investment (i.e. cash).

    How is gold going to yield you any interest? My understanding about gold is that it pays zero interest. That is one of its shortcomings.

  4. John Creighton says

    I originally posted this as s243a but I think it got turfed when you got rid of intense debate:

    If you pay someone to store your gold then it yields zero interest just as cash would yield zero interest if you put it in a safe deposit box. Money deposited in a bank pays interest because you give the bank permission to loan out that money. Thus when you put money in a bank for safe keeping you are not really depositing the money in the bank for safe keeping you are loaning them the money and that is why it is pays interest.

    If you loan someone an asset that is fungible

    Then they can sell that asset and invest it in something that yields a higher return. When it is time for the loan to be repaid then then buy back the asset and return it to you. This ia a cary trade.

    Examples of carry trades are the gold carry trade…

    short selling:

    and the spread trade

    So now with respect to gold, we know that if we just wanted to store it then there would be a storage fee but if we gave the place we stored it at permission to lend out a fraction of that gold then the storage fee would be less and we might even be able to make some interest on that gold. Now I suggested gold as a hedge against inflation and that is probably overly conservative as there are lots of companies paying high dividends and equaties should also be a hedge against inflation.

    I agree that long term bonds are risky due to their price sensitivity to interest rates but that is why they can potentially give such high returns. I don’t expect interest rates to be low any longer then 10 years that is why I suggested going long on the 10 year municipal and short on the 30 year treasury. It protects you against inflation because the net value of your equity in bonds would be roughly zero. I find the proposition attractive because in thoery you can make money on the difference in interest rates (since the 10 year municipal AAA bond pays more then the 30 year treasury) without have any net dollars invested in bonds. Clearly if we are concerned about risk we would buy bonds that are much shorter in duration and possible even protected against inflation. See TIPS. Or even keep money in cash as you suggest.

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