Why Treasuries May be Fairly Valued
I’ve written a some commentary on why I believe that the Treasury bubble is going to burst sooner or later. There are, however, a number of reasons for why what we’re seeing in the Treasury market may not be a bubble after all. The arguments below are taken from sources such as Capital Daily, Brad Setser, Merrill Lynch, Goldman Sachs and comments on my previous posts.
Argument #1: Low yields are justified as we are entering a period of sustained economic downturn, prolonged ZIRP and low inflation if not deflation.
If things continue to get worse, Treasuries may well continue to be the preferred safe haven asset for domestic and foreign investors alike. The general view coming out of Davos seems to be that we are in a severe global recession that will last through (or even beyond) the end of 2009. Market expectations, though, are still overly optimistic: Fed Funds futures are pricing in a rate increase by the end of the year. As market expectations slowly converge with economic reality, risk appetite will stay low and Treasury prices will remain steady. I personally believe this is the strongest argument against the ‘bubble’ hypothesis.
Argument #2: There is no reason to be concerned about the increase in issuance because the economic and financial conditions which prompt this increase simultaneously prompt a flight to safety.
Yes, issuance is increasing drastically – but it is increasing only because of the dire state of the economy, which goes hand in hand with a generally pessimistic outlook, high volatility with poor equities returns, low risk appetite, and investors’ flight to safety. This is an argument that I don’t buy, because you can easily reverse it: increasing issuance of Treasury bonds is a byproduct of the government’s attempt to restore investor confidence. Once the government succeeds, the flight to safety will abate and Treasury prices are going to come down.
Argument #3: Increased issuance and potentially stagnating foreign demand will be offset by increasing domestic savings rates, particularly by baby boomers.
Changing demographics may be a driving factor behind keeping Treasury supply and demand balanced despite increasing issuance and the potential drop off of foreign demand. The domestic savings rate is increasing, and the urgent need of baby boomers to save in order to fund their retirement will provide an increasing source of demand for Treasuries.
I’m on the edge about this argument. It is true that we are seeing an increase in the savings rate today after its short dip into negative territory in 2005. It is also true that the roughly 78m baby boomers are facing a savings crunch which was drastically exacerbated by the developments of the last eighteen months. At the same time, though, according to Corridor Inc. 20% of baby boomers have stopped contributing to retirement plans due to economic hardship. This leaves us with roughly 62.4m baby boomers who are actively saving. Some quick back-of-the-envelope math with simplified assumptions: the 2009 budget deficit is expected to reach $1.2 trillion, representing a ~10% increase to current national debt outstanding ($10.6 trillion). If we assume that Chinese demand falls off a cliff and China does not increase its ~$750 billion of Treasury holdings by 10% in fiscal 2009 (big assumption, I know), a demand gap of roughly $70 to $80 billion would need to be filled – translating into $1,100 of additional savings per baby boomer. That seems plausible in my opinion. At the same time there are so many moving parts in this equation – foreign demand, dollar strength or weakness, domestic risk appetite, savings rates – that I can only say: I don’t know what’s going to happen, but the sheer magnitude of the increase in supply makes me feel uncomfortable.
Argument #4: The government is firmly committed to quantitative easing and will keep yields down.
Ben Bernanke has made clear that the Fed is prepared to buy Treasuries, and the US government has strong incentives to keep rates as low as possible. Increasing yields in longer-dated Treasuries mean the housing market will continue to spiral downward as rates on fixed rate mortgages increase and other collateralized loans become more expensive. The negative wealth effect created by increasing borrowing costs will translate into even lower consumer confidence and consumer spending, and the effect will be doubly negative because borrowing is particularly important in times of high unemployment as credit is needed to bridge the income gap. I do believe that the government is fully committed to doing everything they can to keep yields low – but I also believe that what the government actually can do is limited; at some point, the government will run out of resources to keep yields down. To put numbers to it: a record $1.2 trillion of new issuance is expected in 2009; the Fed currently owns $475 billion of Treasuries, and the Fed’s total balance sheet stands at $2 trillion – but only because it has grown by more than 100% over the last twelve months. In my mind, if foreign and private domestic buyers decide to exit the Treasuries market there will be a whole that’s too big for the Federal Reserve to plug. At that point, quantitative easing will fail and the Treasury bubble will burst.
My verdict remains as before: I like short-dated Treasuries in a portfolio as disaster insurance, but would stay away from the long end of the curve because I am worried that yields will return to higher levels sooner or later. What do you think? In your opinion, what is the strongest argument in favor of Treasuries and against the ‘bubble’ hypothesis?