Are U.S. Treasuries a Buy?

Are U.S. Treasuries a buy at current levels? It sounds like a nutty question… and yet there is an actual case to be made.

Should you be buying U.S. Treasuries? It sounds like a nutty question at first glance. Uncle Sam, after all, is looking more and more like a lousy credit risk with each passing day.

And yet someone is buying Treasuries – and buying in size.

The iShares Barclays 7-10 Year Treasury ETF (IEF:NYSE) tells the tale. The trend for the 10-year note has been up, not down, for the year 2010 thus far. The red circles show dramatic spikes in volume. Given that IEF is now headed upwards, we can surmise these spikes show highly motivated buyers.

In addition to aggressive ETF buying, there has been a large “mystery direct bidder” (or perhaps more than one) taking huge amounts of Treasuries directly from the source in recent weeks. As the Financial Times reported on Jan. 14, “Somebody, or a group of people, have bid directly with the Treasury and took more than 17% of the issue on offer. This is very rare… most investors still go through the primary dealer banks…”

What the FT news amounts to is that someone with very, very deep pockets – on the order of a large foreign central bank, or perhaps a savvy global hedge fund with billions under management – is attempting to build a very big bond position in secret.

Now let’s take a look at long bonds – specifically the iShares T-Bond 20+year ETF (TLT:NYSE).

Long bonds have been in a bull market for many years. Based on the monthly trend, one could argue the bull is still intact.

The huge spike you see at the end of 2008 came during the peak of the global financial crisis, when investors the world over panicked into Treasuries as a holding of last resort. Long bonds have come down since then, but they are arguably still on trend.

All Hat and No Cattle

The logic for selling U.S. Treasuries is fairly straightforward. America is drowning in a sea of debt, both public and private. One has to wonder how there can be appetite for much more.

Recent figures put the total public debt at $12.245 trillion – within spitting distance of the $12.394 trillion statutory limit. (They are going to have to do something about that rather quickly.)

In further effort to soothe public anxiety (and placate public anger), President Obama is expected to unveil a “three-year spending freeze” this week. And yet, as with many other political initiatives, this sounds good on paper but utterly flops in the real world. The “freeze” only applies to 17% of spending, and will do precious little to shrink the $1.4 trillion deficit.

Washington’s habit of being “all hat and no cattle” when it comes to reduced spending is another reason to be bearish on USTs. The great leviathan (i.e. government) has been expanding at record pace. Debt and deficits stretch out as far as the eye can see.

But again, the question remains. Given this bearish backdrop, why is anyone buying Treasuries (let alone buying in size)? The answer goes back to an area of great debate – future expectations for inflation, deflation and economic growth.

Malaise and Deflation Ahead?

The chart above shows the interest rate yield on 30-year Treasuries (i.e. long bonds). Rates move inversely to the price of bonds. That is to say: When bond prices fall, interest rates go up. When bond prices rise, interest rates go down.

By the end of 2008 – a spectacular year for long bonds – the long-term interest rate had plummeted to an incredibly low 2.6% (as you can see on the chart). As the 2009 stimulus took hold and the global economy recovered, the long-term interest rate crept back up, to its present level around 4.6%.

Those who see Treasuries as a buy believe long-term interest rates are going to fall once again. (Short-term rates can’t fall any more because they are basically at zero.) And why are interest rates going to fall once again? Because we have not yet escaped the grip of deflation, the bond bulls say, and recovery has largely been an illusion.

The Case for Deflation

If we head into a period of deflation, equities and inflation-linked investments will no longer look attractive. Consumers, focused on saving and paying down debt, will shift more of their available cash into the safety of bonds. Stagnant wages, chronic unemployment and excess capacity in a wide swathe of industries will guarantee slack prices and low morale. Government efforts to get the economy going will be like trying to start an old lawnmower… other than pulling and sweating and cursing, not a whole lot will happen at all.

The deflationists further argue that America is repeating the Japan experience. The entire world has been surprised at Japan’s seemingly endless domestic appetite for JGBs (Japanese Government Bonds) that yield next to nothing. This is the deflationary experience, the bond bulls say. In the United States, tepid economic growth will fuel a similar domestic appetite for bonds.

In further irony, the very weight of the public debt itself is expected to hamper economic growth.

Carmen Reinhart and Kenneth Rogoff are two highly respected economists who have done extensive research on financial crises and the long-run effects of excess debt. In a recent study based on data from 44 countries over 200 years or so, Reinhart and Rogoff report that “the relationship between government debt and real GDP growth is weak for debt/GDP ratios below a threshold of 90 percent of GDP. Above 90 percent, median growth rates fall by one percent, and average growth falls considerably more.”

At $12.2 trillion and climbing, U.S. public debt is right around 90% of GDP. As it climbs further, America moves further into the well-established dead zone where growth stalls out.

Questioning Inflation

So are the bond bulls crazy? It’s hard to say. If we get serious inflation, bonds will certainly get slaughtered. (Of course, if they expected that to happen, they wouldn’t be bond bulls.)

To quickly recap, the case for serious inflation is more or less based on four inputs:

• Trillions in excess reserves created by the Bernanke Fed
• Loss of faith in Uncle Sam (a mass credit downgrade of the U.S. government)
• Supply and demand issues vis-à-vis large issuances of new debt (no one left to buy)
• Prospects for renewed economic growth (idle bank reserves flooding the system)

Deflationist bond bulls have answers to each one of the above points. They believe the multitrillion-dollar rescue effort, impressive as it may appear, actually pales in comparison to the size of the problem – like throwing a mattress into a volcano.

They further believe that talk of sovereign credit downgrades are overdone (still no viable U.S. substitute); that buyers of new U.S. debt will materialize (just as they have in Japan); and that due to economic slowdown, idle bank reserves will not be deployed any time soon.

Heed the Charts

Your humble editor’s advice? Heed the charts.

In the long run, serious inflation seems assured. If monetary history is any sort of guide, Western world governments will ultimately print themselves into oblivion. Barring that, compelling new growth-oriented opportunities will arise at some point, tempting timid savers away from their low-yield bond holdings.

And yet, the long run is very long. Waiting for inflation could well be like waiting for Godot (or waiting for the JGB bond bubble to burst).

From an investing perspective, your editor would not touch Treasuries with a 10-foot pole. He is happy to toss them into Charlie Munger’s “too hard” bucket and let someone else make that call. From a more nimble-footed trading perspective, the deflationist bond bulls do not have to be right forever… they only have to be right for a little while. And in the here and now, with the stock market looking jittery and a “flight to safety” mentality returning to the fore, the charts appear to be on the bond bulls’ side.

If you have thoughts, questions or insights to share – as related to USTs or the greater inflation/deflation debate in general – by all means send them here: justice@taipaindaily.com

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