Amid the most treacherous real estate and financial markets in the post war period, US Treasuries have become the ultimate “mattress” into which nervous investors have stuffed money. While no one doubts the prudence of insurance against a collapse of the system and years of economic misery, can there come a point when the premiums for that insurance are too expensive? Could Treasury investors be buying into a bubble that rivals the internet bubble of the late 90s, the housing bubble of earlier in this decade, or the oil bubble of last summer?
No one disputes that Treasuries have been bid up to record levels. As prices go up, the yield on Treasuries drops. This December has seen the yield on the 10 year Treasury sink to just 2.2%. That’s the lowest since such yields have been monitored by the Federal Reserve, starting back in 1962.
Meanwhile, the three month Treasury’s yield has fallen below 0%, a negative interest rate. Imagine, effectively paying the Government to hold on to your money. That’s an expensive mattress.
At the very other end of the spectrum the 30 year Treasury’s yield has fallen to 2.72%. Hard to think that makes sense, given that’s a pretax return and inflation has averaged nearly 3.5% annually going back to 1913.
Forecast
Bubbles always burst. What goes up will come down. That’s the history of financial markets, going all the way back to the Dutch tulip mania, the South Seas bubble, the 1800s bubble in railroad bonds, and the bubbles of the roaring 1920s.
This one will end badly, too. Catalysts for a major sell off in Treasury bonds? The economy recovers, stocks soar, and investors see little reason for holding low yielding Government bonds. In other words, appetite for risk returns.
Or, the economy doesn’t soar, but inflation does, and investors dump Treasuries out of fear they do little to offset loss of purchasing power.
Or, investors simply fear that there’s too much Government debt, and supply overwhelms demand. A rush to jumpstart the economy by bailing our debtors and initiating expensive infrastructure projects has shunted budgetary considerations aside; massive new Government borrowing can be expected.
While investors at the very short end are unlikely to get hurt, as they simply incur the opportunity cost of getting a zero return on their money while they could be doing better, holders of longer dated bonds could easily incur major losses. Just this year, the exchange traded fund iShares Barclays 20+ Year Treasury Bond (TLT), holding nothing but long dated Treasuries, is up 30%. If yields simply rise to where they were at the start of 2008 (4.45% versus the current 2.72%), investors could be handed a significant double digit percentage loss.
The paradox is, what looks to be the safest security today, bonds with the full faith and credit of the United States Government, could easily be the riskiest! That’s the danger of bubbles.
Why the Low Treasury Yields?
Fears about slowing economic growth, deflation, and credit risk have produced these record low interest rates.
The US economy entered into a recession in December 2007, and forecasts now are for this recession to the worst in at least 25 years, pushing unemployment to 8% or more. Recession is anathema to corporate profits, making stocks and corporate bonds unattractive relative to Treasuries. The US government has the tools of taxation and ultimately the printing press to pay off its debts. Weak economic conditions also depress loan demand, adding further downward pressure on interest rates.
Interest rates also compensate holders for inflation. But, with one of the sharpest drops in commodity prices ever since July, inflation fears have morphed into deflation fears. Indeed, the consumer price index dropped a bigger than expected 1.7% in November. With inflation a no show, Treasury buyers accept lower interest rates.
The best way to gauge investors’ inflation expectations is to compare a conventional Treasury bond with a TIPS of the same maturity. TIPS, or Treasury Inflation Protection Securities, differ from conventional Treasuries because an investors’ principal is periodically adjusted to reflect changes in the CPI, in addition to paying an albeit smaller rate of interest. By comparing that smaller rate of interest with the conventional Treasury’s yield, you can measure inflation expectations.
That analysis shows that inflation is expected to average less than 0.6% a year for the next decade, down from 2.67% as recently as March. Investors are satisfied with low Treasury yields as long as expected inflation is low or deflation is feared.
The credit crisis has also sparked safe haven buying. Following the collapse of Lehman and the ensuing default by at least one major money market fund, corporate treasurers and other money managers yanked their money out of money market funds, causing extreme fear in the market for short dated corporate loans, also known as commercial paper. The goal was safety at any cost, which has led to the anomaly of negative interest rates, where financiers will literally pay for the privilege of storing their liquidity in complete safety. As long as that focus remains, expect the demand for Treasuries to remain strong, and their yields miniscule.
As Treasury yields on extremely short dated paper hover around zero percent, money market funds have increasing trouble showing positive yields, after expenses. Over 100 money market funds now pay no yield, and that number is expected to grow.
Finally, the Federal Reserve has become an active buyer of Treasuries. It wants to revive the economy by incenting lenders to make loans to the public. Reducing US Treasury interest rates motivates lenders to take on more risk in the search for higher returns. Of course, if the economy stabilizes the Federal Reserve may turn around and sell Treasuries back into the market to sop up excess liquidity, pushing rates back up.
Strategy
There’s nothing wrong with holding short dated Treasuries for short term needs. Sure, the yield may be non existent but that’s the cost of avoiding any risk of not being able to pay your near term bills. Traditionally, people have not expected interest on their checking accounts.
The problem arises when investors remain enchanted with the security of the Government guaranty but feel that they must reach for yield and lengthen their maturities. While the yield on the 30 year Treasury is nearly 3% more than the 3 month yield, if interest rates retrace this year’s course in 2009, investors could be saddled with a 30% loss. To risk 30% for an extra 3% is not smart.
Investors may want to look at FDIC insured corporate debt, enabled by very recent legislation. For example, Deere, the agricultural machine maker, just issued such debt. Despite this unqualified Government support, the buyers received nearly 2% more interest than similarly dated Treasuries.
TIPS also make sense if you believe inflation will push Treasury yields higher. With a TIPS, you have the complete safety of the Treasury backing, plus complete protection from changes in the Consumer Price Index. As yields on TIPS reflect very slim projected inflation rates, this may be an excellent time to switch to these securities.
In sum, investor euphoria for US Treasuries, the safest security from a credit perspective, has pushed their yields down to record low levels. Any pick up in the economy, inflation rates, or risk appetite could devastate holders as yields rise.
By David G. Dietze, JD, CFA, CFP™
President and Chief Investment Strategist
Point View Financial Services, Inc.
Summit, NJ
www.ptview.com
December 18, 2008
No one disputes that Treasuries have been bid up to record levels. As prices go up, the yield on Treasuries drops. This December has seen the yield on the 10 year Treasury sink to just 2.2%. That’s the lowest since such yields have been monitored by the Federal Reserve, starting back in 1962.
Meanwhile, the three month Treasury’s yield has fallen below 0%, a negative interest rate. Imagine, effectively paying the Government to hold on to your money. That’s an expensive mattress.
At the very other end of the spectrum the 30 year Treasury’s yield has fallen to 2.72%. Hard to think that makes sense, given that’s a pretax return and inflation has averaged nearly 3.5% annually going back to 1913.
Forecast
Bubbles always burst. What goes up will come down. That’s the history of financial markets, going all the way back to the Dutch tulip mania, the South Seas bubble, the 1800s bubble in railroad bonds, and the bubbles of the roaring 1920s.
This one will end badly, too. Catalysts for a major sell off in Treasury bonds? The economy recovers, stocks soar, and investors see little reason for holding low yielding Government bonds. In other words, appetite for risk returns.
Or, the economy doesn’t soar, but inflation does, and investors dump Treasuries out of fear they do little to offset loss of purchasing power.
Or, investors simply fear that there’s too much Government debt, and supply overwhelms demand. A rush to jumpstart the economy by bailing our debtors and initiating expensive infrastructure projects has shunted budgetary considerations aside; massive new Government borrowing can be expected.
While investors at the very short end are unlikely to get hurt, as they simply incur the opportunity cost of getting a zero return on their money while they could be doing better, holders of longer dated bonds could easily incur major losses. Just this year, the exchange traded fund iShares Barclays 20+ Year Treasury Bond (TLT), holding nothing but long dated Treasuries, is up 30%. If yields simply rise to where they were at the start of 2008 (4.45% versus the current 2.72%), investors could be handed a significant double digit percentage loss.
The paradox is, what looks to be the safest security today, bonds with the full faith and credit of the United States Government, could easily be the riskiest! That’s the danger of bubbles.
Why the Low Treasury Yields?
Fears about slowing economic growth, deflation, and credit risk have produced these record low interest rates.
The US economy entered into a recession in December 2007, and forecasts now are for this recession to the worst in at least 25 years, pushing unemployment to 8% or more. Recession is anathema to corporate profits, making stocks and corporate bonds unattractive relative to Treasuries. The US government has the tools of taxation and ultimately the printing press to pay off its debts. Weak economic conditions also depress loan demand, adding further downward pressure on interest rates.
Interest rates also compensate holders for inflation. But, with one of the sharpest drops in commodity prices ever since July, inflation fears have morphed into deflation fears. Indeed, the consumer price index dropped a bigger than expected 1.7% in November. With inflation a no show, Treasury buyers accept lower interest rates.
The best way to gauge investors’ inflation expectations is to compare a conventional Treasury bond with a TIPS of the same maturity. TIPS, or Treasury Inflation Protection Securities, differ from conventional Treasuries because an investors’ principal is periodically adjusted to reflect changes in the CPI, in addition to paying an albeit smaller rate of interest. By comparing that smaller rate of interest with the conventional Treasury’s yield, you can measure inflation expectations.
That analysis shows that inflation is expected to average less than 0.6% a year for the next decade, down from 2.67% as recently as March. Investors are satisfied with low Treasury yields as long as expected inflation is low or deflation is feared.
The credit crisis has also sparked safe haven buying. Following the collapse of Lehman and the ensuing default by at least one major money market fund, corporate treasurers and other money managers yanked their money out of money market funds, causing extreme fear in the market for short dated corporate loans, also known as commercial paper. The goal was safety at any cost, which has led to the anomaly of negative interest rates, where financiers will literally pay for the privilege of storing their liquidity in complete safety. As long as that focus remains, expect the demand for Treasuries to remain strong, and their yields miniscule.
As Treasury yields on extremely short dated paper hover around zero percent, money market funds have increasing trouble showing positive yields, after expenses. Over 100 money market funds now pay no yield, and that number is expected to grow.
Finally, the Federal Reserve has become an active buyer of Treasuries. It wants to revive the economy by incenting lenders to make loans to the public. Reducing US Treasury interest rates motivates lenders to take on more risk in the search for higher returns. Of course, if the economy stabilizes the Federal Reserve may turn around and sell Treasuries back into the market to sop up excess liquidity, pushing rates back up.
Strategy
There’s nothing wrong with holding short dated Treasuries for short term needs. Sure, the yield may be non existent but that’s the cost of avoiding any risk of not being able to pay your near term bills. Traditionally, people have not expected interest on their checking accounts.
The problem arises when investors remain enchanted with the security of the Government guaranty but feel that they must reach for yield and lengthen their maturities. While the yield on the 30 year Treasury is nearly 3% more than the 3 month yield, if interest rates retrace this year’s course in 2009, investors could be saddled with a 30% loss. To risk 30% for an extra 3% is not smart.
Investors may want to look at FDIC insured corporate debt, enabled by very recent legislation. For example, Deere, the agricultural machine maker, just issued such debt. Despite this unqualified Government support, the buyers received nearly 2% more interest than similarly dated Treasuries.
TIPS also make sense if you believe inflation will push Treasury yields higher. With a TIPS, you have the complete safety of the Treasury backing, plus complete protection from changes in the Consumer Price Index. As yields on TIPS reflect very slim projected inflation rates, this may be an excellent time to switch to these securities.
In sum, investor euphoria for US Treasuries, the safest security from a credit perspective, has pushed their yields down to record low levels. Any pick up in the economy, inflation rates, or risk appetite could devastate holders as yields rise.
By David G. Dietze, JD, CFA, CFP™
President and Chief Investment Strategist
Point View Financial Services, Inc.
Summit, NJ
www.ptview.com
December 18, 2008
