Treasuries: The Next Bubble?

We’ve survived the tech bubble and the housing bubble, but are we headed for something more catastrophic than either of those?  Some experts are beginning to fear the worst.

Let’s review recent financial events. The meltdown in the global financial markets created a wave of panic and a surge of money has poured into what has always been considered safe—short-term U.S. Treasury securities.  This basically means that investors are willing to put faith in and lend money to the government.  Primarily because, even though our national debt stands at staggering $10.59 trillion, and is still growing, the U.S. has never failed to meet a debt payment. This sudden appetite for Treasuries has driven yields down to their lowest levels since the Great Depression.

Over the past couple of months, the Feds have funneled massive amounts into bailout packages upsetting the government’s balance sheet.  When you add a soaring U.S. deficit into the mix, you get a situation that’s causing sleepless nights for anyone that’s paying attention.

How Low Can They Go?

We’ve been waiting to see just how low interest rates on Treasury securities could go before the rapid stream of investments would dry up.  It now appears that even zero is not too low. One day during the second week of December, the annualized yield on three-month T-bills in the secondary market hit the minus zero level, down to negative 0.01%, then later that same day it rose to positive 0.01%.

This means that investors are so fearful of the markets, but still have enough faith that the U.S. government, they are willing to risk getting less money upon maturity than they originally invested, and earn no interest along the way.

The Treasury hasn't had to auction new T-bills at a negative rate yet, but on December 8, they actually sold $30 billion in four-week T-bills at a yield of exactly zero. Anyone who bought those can sell them in four weeks, but not for one penny more than they paid for them. At that rate, you could have just as easily stuffed a fistful of $100 bills into a coffee can and buried it in the back yard.

You might be wondering who would be willing to buy Treasury debt for little or no return?  It turns out that there were plenty lined up to buy—some who probably no longer have back yards—so many in fact that the Feds reportedly could have sold up to four times as much as they did. Actually, while there are plenty of individual investors, it’s the big institutional investors like pension funds, and international central banks that are the biggest players in the market for Treasury securities.

How Long Can it Last?

There is so much money shifting into Treasuries, it can’t last forever. Investors seem to be pouring money into government securities with the same fervor that they did during the housing surge and the dotcom mania. U.S. government debt has always been considered the safest investment in the world.  But now some fear the Treasury market is venturing into bubble territory.

The big question becomes, “How long can it last?”  Were a bubble of this size to implode, there wouldn’t be enough sand bags in the world to stop the flood of money that would come gushing out. When the torrent was over, there would be so little left in the Treasury coffers, the government would be forced to pay higher rates on their burgeoning debt.

Our Foreign Debt Holders

 If such a day of reckoning is coming, it would be a devastating blow to the economy, and the dollar.  At the first sign of the stock market entering a sustained period of recovery, investors would shy away from low-yield Treasuries. The Fed could then be forced to monetize Treasury securities, or else boost the rates higher.

But China and other foreign countries hold a major chunk of U.S. debt. In fact, about half of the nation's $5.3 trillion in publicly traded debt is held by countries like Japan and China. That means a significant down shift in Treasury prices would lead to the decline of the US dollar, a threat of hyper-inflation and finally, a depression. 

And yet, even though the U.S. has the dubious distinction of having kicked off the firestorm of global economic meltdown, our government bonds are still considered the safest investments in the world.

What’s in Store?

Just like we all thought that the price of homes could only go up, we now know that it’s that kind of irrational exuberance that blind us what’s coming.  Jim Grant of Grant's Interest Rate Observer recently commented on CNBC, "There's more risk in things people think are inherently safe, including cash and Treasuries, vs. the things people perceive as risky."

It appears that even though Treasury yields are at an all time low, even institutional investors are more concerned about preserving capital than they are in getting higher returns. Treasury interest rates are already at or near zero.

If things get worse, and they slip further into negative return territory, would investors actually be willing to pay the government to hold their money for safe keeping?  So far, there is no indication that things will get that dire. Although, since none of the rules we’ve lived by these past few decades seem to apply anymore, we can’t speculate on the future.

We think that Treasury interest rates will probably remain low until some time mid-2009, or at least until the recession begins to lighten up.  If the skittish market keeps the fear factor alive, people will keep moving money into the Treasury for safekeeping, low interest rates or not.