Readers have recently asked for my take on the US Treasury markets. Without a question, that is the hot topic issue of the last few weeks, and inquiring minds are wondering how it "fits" within the larger trend of debt deflation.
I had been a treasury bull for years while many were saying they were worthless trash. In my Themes for 2009 series, I turned cautious:
One area I have my eye on is the US Treasury market. I have been bullish on treasuries for a couple years now. The move over the last few weeks has been stunning. The US Fed has announced that they may start buying these securities as part of their Quantitative Easing programs. Are treasury traders and investors using the same logic as they were for oil in July? Are they using the Fed's intervention threat as justification for believing “prices can't go down?” Just the same as we were hearing “oil can't go down because of peak oil.” Will we all look back at the seemingly bizarre recent occurrence of the US Dollar falling/Treasuries rising as a very obvious hint of irrational exuberance?
I did not have the mettle to short treasuries from those levels, but I am thankful to have recognized the parabolic rise as unsustainable and happily moved out of the way. Now that the market appears to have collapsed despite the Fed's intervention to keep rates low, treasury bears are having their turn in the sun. But most likely not for the reasons they suggest.
It is true that rising interest rates are indicative of increasing inflation expectations. But there are other reasons interest rates rise. They can also rise due to shifting time preferences of investors. If people decide they want higher returns on their capital, they will shift their money to riskier assets in order to try to benefit. In an age where millions of baby boomers and pension funds are realizing they don't have nearly as much as they thought they would, this is a very real potential catalyst. Chasing high returns to make up for previous losses always ends up in tears, but that has never stopped investment managers from doing it over and over again. There is another major reason for interest rates to rise. That is risk of default. And it is a possibility that many have likely not given as much attention to as they should.
With the Fed "printing money" (ie. making credit available) like there is no tomorrow and the treasury spending in kind, inflation seems like a pretty safe bet. But keep in mind that Hoover tried the same thing in '30/'31, and was met with nothing. Ironically, the government's increasing deficits were what had foreign investors so concerned, because they felt the US would not be able to repay their obligations in gold. The Fed subsequently raised interest rates to stem the outflow of redemptions, which eventually killed the economy dead. That increase in interest rates is what Bernanke contends (remember, he is an "expert" on the depression) was the leading cause of the Great Depression.
Foreign concern about a default on gold obligations turned out to be justified. Roosevelt effectively defaulted in '33 when he confiscated all private holdings of gold and devalued it by half. I find it surprising that so many feel such a similar outcome is unlikely to repeat itself. Especially considering that a large percentage of outstanding treasuries are held by foreigners that aren't exactly "friendly." Default could be strategically beneficial. Especially if it were done soon and a majority of it could be blamed on Bush - something Obama has displayed he is fond of doing.
A default would not have to be absolute. Most sovereign defaults are not. They typically just restructure their debt. I can see a situation where the Obama Administration unilaterally decides which holders of which debt are repaid on what terms. He has already demonstrated the will to interfere in contract law in the meddling with Chrysler and GM bankruptcies. If he thinks it fair to stiff the Chinese and other creditors he deems as disposable (hedge funds, for example) in order to free up the funds to provide his dream of socialized medicine, he'll do it. There are no rules in Washington. The messiah will do whatever he wants. And if anyone objects, he can merely defend himself by countering that "Bush did it and the Republicans didn't say anything then."
But the major reason that I do not see the recent drop in treasuries as a signal of future inflation is that there has been little to no follow-through from corporate debt. If the inflation concerns were real, we should be seeing commensurate declines in investment grade corporate bonds and the high yield variety. Investors flee all bond markets when they get a whiff of inflation because they know their purchasing power will be destroyed. There has been no flight from the corporate bond markets.
High Yield Corporate Bond Index
Investment Grade Corporate Bond Index
I don't want to turn this post into another long-winded diatribe on inflation/deflation, but I have heard quite a few suggest that a Treasury default would be hyperinflationary. I suppose it would for holders of the treasuries that were defaulted on. But for anyone else, it would have a deflationary impact. The reason is simple. Less credit in the system means a drop in the existing supply of money and credit.
How does a dollar hold its value if the treasury defaults, when the Fed's main balance sheet component (what gives the dollar value) is treasuries? Simple. The Administration simply orders the Fed's Treasury liabilities to be guaranteed while others are not. After the first 4 months of lawlessness in the Obama administration, does anyone believe he would not do this?
That said, I would not be inclined to bet against the inflation trade as of yet. Interest rates could still rise substantially before Geithner (or his replacement) decides that default is the only real option. Then again, there is a good argument to be made that the current rise in interest rates is simply volatility that has shifted from the stock market to the government and mortgage debt markets. Tyler Durden at Zero Hedge has also been meticulously following the massive short squeeze going on in the junk bond markets comparative to treasuries. Is this all nothing more than the big banks getting money from the taxpayer and using it to bail themselves out by betting against quant hedge funds that had been massively short anything risky? These are questions one needs to ask oneself if they were betting on a looming hyperinflation after the last few weeks of rising rates. Econompic Data has some good illustrations of the above points:
First are the year to date performance of various credit instruments. Anyone long treasuries and short junk has been effectively destroyed.
Next is the year over year spread between treasuries and junk over the last 25 years. "An unprecedented selloff is now an unprecedented rebound," writes Econompic.
I would also point out that with treasury yields spiking, mortgage rates have also risen rapidly. Some brokerages were reporting the costs of fixed rate mortgages rose .75 bps in only two days this week. That is a big difference for someone with a $300,000 mortgage and will certainly not help in preventing foreclosures. The amount of homes entering foreclosure and the number of Americans underwater on their mortgages was already accelerating before the recent events. Surely, if high rates persist, another stunning drop in home prices could result in further economic deleveraging - this time with commercial real estate providing wind at its back. All of this is deflationary and all of this is without mentioning the social and generational trends that suggest deflation is inevitable.
In summary, there seems to be quite a bit of confusion as to what the recent spike in rates means for the overall economic outlook. I don't pretend to know exactly what will transpire. But from what I can see, the risk of a stealth default is being drastically underestimated and its impact is being perceived as more inflationary than a closer look would otherwise suggest.
I anticipate this to be a matter of continuing interest...
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