Monday, November 19, 2012

Is it a Bond Market Bubble?

Are U.S. Treasuries the most dangerous investment in the world right now? They might very well be. Although Treasuries have had a successful thirty year run, with yields currently at record lows, three factors could lead to a tremendous spike in yields. They are: 1.) an end to the flight to safety; 2.) massive government debts and ensuing inflation; and 3.) the lessening of foreign government investment in Treasuries.

The first factor is an end to the flight to safety. The first phase of the flight to safety occurred in 2009, when the subprime mortgage crisis led to the bankruptcies of Lehman Brothers and Bear Stearns, as well as to the collapse of global stock markets. As a result, foreign and domestic investors sought refuge from the turbulent global markets by investing in U.S. Treasuries. The second phase of the flight to safety—which continues to this day—was triggered in late 2009 when fears arose over the ability of Greece to meet its debt obligations. The flight to safety intensified when concerns over the debt levels of other Eurozone nations came into question. During this second phase of the flight to safety, yields on 10-year Treasury bonds tumbled from around 3.5% at the beginning of 2011 to around 1.6% where they remain today. As one can see from the chart, yields have remained at record low levels ever since the start of the Eurozone debt crisis.

But this flight to safety will end when investors see that the U.S. economy is recovering. Investors will sell Treasuries in pursuit of higher returns in other asset classes.

Already, the U.S. economy is showing signs of strength. Although unemployment remains at an elevated level, job market indicators have started to improve. Further, as I wrote in my previous article, it appears that U.S. real estate is in recovery mode. Jamie Dimon, CEO of JPMorgan, recently commented that, “every single thing about housing is flashing green. There’s not one thing that’s flashing red.”

But discussion of a flight away from safety aside, there are other reasons to fear Treasuries—namely, the disastrous fiscal position of the United States. The current national debt of the U.S. now stands at approximately $16.2 trillion, which equates to around $52,000 for each person living in the U.S. The debt-to-GDP ratio of the U.S.—now at around 103%--is one of the highest in the world, lagging only behind countries like Italy and Greece. To make matters worse, the government ran a budget deficit in excess of $1 trillion throughout President Obama’s first term.

Yet, the national debt and budget deficit figures only tell part of the story. The U.S. Government is in even greater debt than the official numbers show. The ‘unofficial’ portion of its debt, called ‘unfunded liabilities’, is enormous, and stem mostly from Social Security, Medicare and Medicaid.

Unfunded liabilities are the amount of funds that need to be invested today to finance projected spending in the future. Estimates of unfunded liabilities range from $82 trillion to over $200 trillion. Laurence Kotlikoff, Professor of Economics and Boston University, estimates—using the long-term budget forecast of the Congressional Budget Office—that the total unfunded liabilities of the U.S. Government are around $222 trillion. That is, $222 trillion would have to be invested today to support projected spending in the future. While estimates do vary, one thing is clear—the U.S. Government does not have the funds necessary to support all the benefits it has promised to pay in the future.

The government can’t do much about unfunded liabilities. One option would be raising taxes. But considering that the U.S. has one of the highest tax rates in the world, this option is limited. Closing the unfunded liabilities gap using taxes would require an immediate and permanent increase of 64% in all federal taxes--something that will definitely not happen.

Another option would be rationing, especially in the case of Medicaid. But the amount of benefits that would have to be rationed would be staggering, and would represent an enormous cut in benefits to future recipients.

A further option, of course, is issuing debt to fund future spending. Kent Smetters, Professor of Business Economics and Public Policy at Wharton, believes the government will aggressively issue debt to cover future shortfalls. And international markets, he says, will figure it out. Smetters:
“{International markets] will realize the government is basically monetizing that debt through higher inflation. And if you have an inflation rate that's 2%, 3% more per year than the historic average, you can really eat away a lot of debt just through the law of compounding. And so the market should figure that out and adjust the interest rates accordingly. That's one reason why I believe that 30 year yields right now on Treasury [bonds], especially to non-inflation protected Treasuries, is really too low. I believe Treasuries are in a bubble right now because everybody's flocked to the safety. And there's just no way that those low yields of 3.5% are going to cover the inflation rate over the next 30 years.”
But the question is how much debt the government can issue to fund projected spending before inflation spirals out of control. During the last fiscal year, the Federal Reserve financed around three-quarters of the U.S. budget deficit. The Fed now holds around $1.651 trillion worth of Treasury bonds, which equates to 10% of the total outstanding debt of the U.S. RBS has estimated that next year the Fed will purchase $1.02 trillion out of $1.16 trillion debt issued by the Treasury, leaving only $138 billion for investors around the world.

The reason the Fed has been able to purchase Treasuries in such significant quantities without stoking inflation is that the money it has printed to purchase such assets has ended up right back on its balance sheet in the form of excess reserves. If excess reserves start to drain into the economy, as I have discussed here, there is the risk of significant inflation. Such inflation would severely limit the ability of the Fed to monetize the debt of the U.S. government in the future. An inflation-check on the Fed is another factor that could lead to a rapid rise in interest rates.

Another development that could exacerbate a spike in interest rates is if foreign governments decide to stop buying U.S. debt. China, the largest foreign holder of U.S. Treasuries, has reduced its holdings by approximately 9% since last September. In the past, China was largely viewed as the dominant factor in keeping yields on U.S. Treasuries low. But while China has been aggressively reducing its holdings of U.S. Treasuries, it has had little effect on yields. This is because another player, Japan, has entered the picture. From September 2011 to September 2012, Japan has increased its holdings of U.S. debt by approximately 15%, to $1.131 trillion. If the current trend sustains itself, Japan will pass China to become the largest holder of U.S. Treasuries.

At present, it does appear that the trend will hold. Japan is accumulating U.S. debt in a maneuver to weaken the yen, which has reached record highs. One Japanese official said that the purchases were also desirable because they represent “funds to finance intervention in the future.” Japan also sees the purchases as a way to maintain close military and diplomatic relations with the U.S.

So, for now, the Japanese are picking up the slack from the Chinese. But how long this can last, on one knows. But it is an area to keep a very close eye on.

An eventual end to the flight to safety, a disastrous U.S. fiscal position, inflation, and the threat of foreign governments dumping U.S. debt, this is a dangerous time to be invested in Treasuries, or any fixed income instrument for that matter. More than $2 trillion has flowed into fixed-income funds globally over the past four years, while equities only received $400 billion. Asset manager MFS run some simulations, and estimated that if yields rise from 1.75% to their long term average of 5% by the end of 2017, a $1 million initial investment in 10-year Treasuries would be worth only $690,000, for a real loss of 7% per year. 

Arthur Steinmetz, chief investment officer at Oppenheimer, recently said about investors flocking to bonds, “People, out of fear, are getting poor slowly. I’d like to dump a bucket of cold water on these people and say ‘think about it! Consider the consequences of your choice.’” Steinmetz is correct, it is time for investors to start questioning their investments in U.S. Treasuries, for the spike in interest rates could be near.

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