Today, I wanted to provide two opposing views of the merits of investing in U.S. Treasuries in today’s environment.
Whenever I make investment decisions for clients, I always try to consider arguments both in favor and against the investment. It’s important to understand both sides of any issue and do our best to remove our own personal biases and emotions from the decision. In this particular case, with regards to U.S. Treasuries, both sides of the argument contain valid points causing stark disagreement among even the most respected managers and pundits.
The Bear Case
To summarize the bear (negative) case for investing in U.S. Treasuries at the moment:
- The federal debt is very large both in absolute terms and relative to GDP.
- Closely-tied to point #1 -> budget deficits are also very large and rising.
- Massive unfunded future liabilities (entitlement programs) mean the deficit will continue to increase at an increasing rate.
- Inflation risks
- Foreigners liquidating Treasury holdings
- Tighter monetary policy from the Federal Reserve (higher interest rates and balance sheet reduction)
Federal Debt and Budget Deficits
A Treasury bond is the federal government’s IOU for any debt. The debt represents how much the Federal government owes to its creditors, which include many different people, entities and countries. More debt implies a greater supply of Treasuries in the market. As we know from basic Economics 101, the greater the supply (assuming demand remains constant) then the lower the price required to clear the market. Otherwise, if the price is too high, the market is stuck with an excess supply because there aren’t enough willing and able buyers at that price to soak up all the supply.
Likewise, if the debt is large and budget deficits are also large and growing, that means it’s reasonable to expect government will need to borrow more money (i.e. issue more Treasuries) in the coming years. The market always tries to price in information as soon as it is known, so if the market expects a greater supply of Treasuries the market will price those accordingly (see paragraph above).
Massive Unfunded Liabilities
The debt discussed above represents funded liabilities but does not include any future liabilities like future medicare and social security obligations (just two examples). Due to the nature of our entitlement spending and the obligatory nature of that spending based on the legislative process, the true liabilities of the nation must include that future spending discounted to the present. It’s much like a pension plan that has promised to pay a certain amount of benefits to retiring employees.
So when trying to analyze how much the federal debt will grow, the amount of those future obligations must be discounted to the present and offset with discounted tax revenue to determine any surplus/deficit. Those future obligations represent a massive deficit meaning federal borrowing will likely continue to increase at an accelerating rate unless something is changed. So the market needs to account for that future supply of Treasuries as well. Some estimates of the United States’ unfunded liabilities are in excess of $100 trillion!
Inflation Risks
Inflation is bearish for Treasuries. After all, a Treasury is a promise to pay a fixed amount of money at some future date. Inflation implies a reduction in the value (i.e. purchasing power) of each U.S. Dollar (USD). Therefore, if I lend the government money for 10 years and receive a promise-to-pay / IOU (i.e. Treasury Bond) in return then the price of that IOU MUST account for any appreciation or depreciation in the value of the dollar over the term of the loan. After all, if I loan the government $10,000 but that $10,000 only buys me the equivalent of $5,000 in the future when I’m supposed to be paid back, than the terms of that loan must account for that depreciation in the value of the currency. After all, it’s not how many dollars you get back, but what those dollars can buy.
For a more extreme example, consider someone who loaned the Venezuelan government $10,000 ten years ago in return for 5% interest and repayment of $10,000 ten years from the date of the loan. Well, that’s a raw deal for the lender because the $10,000 of principal paid back today is essentially worthless. So the lender lent something valuable in return for something worthless.
Foreign Government Liquidations
I will refer you back to the first paragraph of this section. If someone is selling a bunch of Treasuries (like a foreign government liquidating its holdings) that will increase the global supply and, therefore, reduce the price of Treasuries, all else being equal.
Tighter Monetary Policy
When the Fed tightens monetary policy by increasing interest rates it pushes the prices of bonds down. A bond’s price and interest rate move inversely. So if a bond was issued at 5% interest but now the market rate is 10% then that bond’s price must adjust (downwards) accordingly so that its yield is commensurate with the prevailing market rate.
Additionally, the Fed has assets that it has purchased. The majority of those assets are U.S. Treasuries. So if the Fed is reducing its balance sheet (i.e. selling Treasuries) then that also increases the supply of Treasuries in the market.
The Bull Case
To summarize the bull (positive) case for U.S Treasuries:
- Slowing economic growth / brink of recession
- Debt deleveraging cycle -> deflation / disinflation
- Extremely high valuations in other assets -> risk-off mentality / flight-to-safety
- Inverse correlations to traditional stock investments
Slowing Growth / Recession
Besides being one of the worst recoveries in terms of GDP growth and wage growth in history (not too mention alongside the greatest financial intervention in history), the U.S. economy also appears to be slowing or even nearing the brink of recession. The deceleration has been quite obvious in the auto, housing and retail sectors over the last year.
Another sign of a potential recession on the horizon is the structure of the yield curve. The yield curve (the difference in yield between Treasuries of different maturities) has become very flat. In other words, the yields on short-term treasuries (<3 years) and longer-term treasuries are about the same. In a healthy economy, short-term rates should be lower than long-term rates. In fact, Hoisington Investment Management referenced a study performed by the San Francisco Fed in their 2018.Q3 letter. That study found that the most reliable predictor of recessions of the various yield curves was the 10-year Treasury to 3-month Treasury curve. When the difference in yield between these two maturities is less than 0.40%, the probability of an economic slowdown becomes quite high. That spread recently fell below 0.4% all the way to 0.25%!
This flat yield curve also makes it difficult for banks to be profitable as they borrow at the short-term rate and lend at the long-term rate so when those rates are about the same, there is very little profit relative to the risk. Therefore, this can result in a slowdown in lending, which puts the brakes on investment and spending while also hurting bank profitability.
Furthermore, government debt-to-GDP is over 100%. Studies have shown that when this ratio exceeds 90% for a sustained period of time, which it has, economic growth suffers. Greater government debt acts as an anchor dragging on the economy’s growth.
Savings rates are very low and savings are necessary for investment. Investment, in turn, is necessary for robust growth. After all, economic growth is simply a function of growth in worker productivity and growth in total hours worked. Investment is necessary to develop new technologies that make workers more productive. To illustrate this concept, consider how much more productive a farmer is with modern combines and tractors than merely with his hands and hand tools. So less investment means less productive workers than otherwise could have been and lower growth than otherwise could have been. Low investment leads to an economy that grows below it’s potential or fails to grow at all!
The reason why this is so important in the context of a discussion of Treasuries is because long-term Treasury rates incorporate economic growth rates. So low growth, all else being equal, may result in lower interest rates for long-term Treasuries, which implies higher prices. Dr. John Hussman has pointed out that, “There’s a 90% correlation between 10-year nominal GDP growth and prevailing 10-year Treasury yields.” So low interest rates could simply be a signal that economic growth is expected to be low for the next decade. In that case, current yields (or even lower yields) may be perfectly justified.
Debt Deleveraging
The catalyst that set off the Great Financial Crisis (2007-2009) was the beginning of a debt deleveraging process that rippled through the economy. The Federal Reserve and federal government responded with monetary and fiscal policies to fight that deleveraging process. They succeeded…temporarily. I believe the various interventions were a terrible mistake as it only delayed and prolonged the inevitable. My view has been that eventually the debt would catch up to us and the resumption of the deleveraging cycle would be even worse because the imbalances were allowed to get so much greater. In other words, the economy was sick and the deleveraging process was the cure. The interventions prevented the cure from working and simply acted as a short-term painkiller numbing the pain but doing nothing to actually cure the disease.
We are beginning to see the deleveraging process resume. Although it probably won’t start in the mortgage market again (no two crises are exactly alike), it appears the catalyst could be in the corporate debt market. I’ve written about these issues here and here so I will not rehash the arguments in detail.
There are a few different causes for deflation (some good, some bad). A debt deleveraging process is one potential cause of deflation. Deflation is not necessarily bad like some economists would have you believe but certainly a debt deleveraging process can be painful for a highly-indebted economy that’s heavily reliant on debt for eeking out even paltry growth (like the U.S.).
Additionally, a deleveraging cycle reduces the supply of dollars in the market and can sometimes create a dollar shortage (low supply). This can cause the value the dollar to increase as demand outstrips supply. A debt deleveraging process can occur simply because households / governments / companies lose either their appetite and / or ability to borrow more money. A debt deleveraging can also occur more rapidly as households / governments / companies outright default on their debt leading to a cascade of defaults and a financial crisis that rapidly spreads throughout the entire economy like a chain of dominoes.
Flight to Safety
Another bullish factor is simply that other assets are far more overvalued so any sign of trouble or a loss in risk appetite from investors causes folks to flee to safety in the form of stable, liquid Treasuries. We saw this transpire in December when U.S. stocks lost over 9% but intermediate-term Treasuries (symbol: IEF) made 2.8%! We also saw this in 2008 when intermediate-term Treasuries made 15% while the stock market lost about 40%!
Correlation / Diversification Benefits
Previously, I mentioned the relative behavior of U.S. Treasuries and U.S. stocks going all the way back to 1928. In that commentary, I noted that U.S. Treasuries and U.S. stocks have lost money in the same calendar year only THREE times in 90 years! Treasuries, at least historically, have been a wonderful diversifier for stocks. You can reduce wild swings in the value of your portfolio by incorporating Treasuries into a portfolio. I believe these diversification benefits will continue for most years going forward.
For any questions on this or how these concepts should be incorporated into your portfolio, give me a call or email me at ken@melottefa.com.
Past performance is no guarantee of future results. All investments maintain risk of loss in addition to gain.
Data from third-parties is believed to be reliable but accuracy is not guaranteed. Much data used to interpret the markets may often be at odds and can result in different conclusions.
This is NOT investment advice but merely a general commentary. Individualized investment advice cannot be provided until a thorough review of your unique circumstances is completed.
