Anything But Treasuries?
There has been much hype recently about the alleged bubble in US Treasuries. After returning more than 20% in 2008, Treasuries are now commonly viewed as a risky investment. Merrill Lynch and Goldman Sachs are among the few who believe that Treasuries are not overly expensive but fairly valued. More or less the rest of the world believes that the Treasury bubble is about to burst. And there is plenty of ammunition for the Treasury bubble view:
- Treasury yields are at historical lows
- issuance is increasing drastically as various domestic bailout packages have to get financed
- money supply in the US is increasing at an unprecedented speed, suggesting the dollar may weaken due to simple over-supply
- a weakening dollar, in combination with extraordinarily low yields, will decrease foreign demand for Treasuries
- Chinese demand for Treasuries will drop as China is struggling to finance its own domestic bailouts
- domestic risk appetite may increase at any time, leading to an investor exodus from the Treasury market.
I am sure that, over time, demand for Treasuries will weaken and yields will mean revert resulting in a sharp correction in prices. Hence my general advice to anyone holding Treasuries in their portfolio (i.e. hopefully everyone) would be to keep the exposure but shift the duration towards the very short end of the curve. I believe that Treasuries have run up in a huge way, and I do believe that they will come crashing down at some point – but I don’t know if it’s going to be tomorrow, in a month or in a year. In addition to not knowing when Treasury prices will correct, I like having Treasuries as a disaster insurance. I just don’t like the idea of potentially losing 20%+ on a long bond portfolio as yields are decompressing.
And here’s why I’m still a believer in Treasuries, even though I think the bubble is going to pop sooner or later:
There is a good chance that we haven’t felt the full effect of the credit crisis yet; if things get worse, there will be increased demand for Treasuries going forward. And while it is true that a weak dollar would decrease foreign demand, central banks around the globe are likely to be cutting rates over the next months as a response to the global slowdown (i.e. the dollar may remain comparatively strong). In addition – and this argument is lifted from Kessler, who recently made a smart case for Treasuries – demand for Treasuries may well increase once Obama puts together a concrete plan of action because political fighting will break out which will undermine confidence in a quick recovery and provoke a renewed flight to safety as the general outlook deteriorates. In addition, the US government has a number of incentives to keep rates as low as possible via the Fed funds target rate and quantitative easing:
- if yields in longer-dated Treasuries increase the housing market will continue to spiral downward as rates on fixed rate mortgages will increase (and so will rates on all other collateralized loans); this creates a negative wealth effect and translates into lower consumer confidence & consumer spending
- higher yields would have a doubly negative effect because borrowing is particularly important in times of high unemployment: credit needs to bridge the gap.
What do you think? Do you still hold Treasuries in your portfolio? And how quickly or slowly do you believe the US economy is going to recover?