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Forex Blog - US Treasuries Are Safe Bet for 2009

US Treasuries Are Safe Bet for 2009


With US Treasury yields ending 2008 at 50-55 year lows, 1-month t-bills yielding 0.00%, the Fed embarking on quantitative easing (printing money) and the incoming administration planning a massive debt-financed fiscal stimulus, the “Bonds for Dummies” manual adherents are warning that 2009 may bring the near demise of the bond market (the new asset bubble).   


Bah humbug.  No question supply of Treasuries will explode in 2009 to pay for everything.  But the idea that economic forces are ready to bounce back to like at the drop of a quantitative easing hat is utter drivel.  Japan wrestled, albeit very ineffectively and inefficiently, with quantitative easing and large fiscal stimulus packages for years before having any impact on inflation and inflation expectations which must happen to restore risk taking, business investment (a form or risk taking) and consumption (a form of risk taking).  And through Japan’s experience of quantitative easing JGB yields remained depressed, even after the policy yielded some successes by mid-2000s.  Many JGB shorts had lots of L and no P on betting QE in Japan would drive yields up.


But the US is not Japan.  True.  Japan has a high savings rate and US a low savings rate.  Japan’s private domestic savings could absorb much of the debt issuance without seeing yields on government debt rise much.  Moreover, the BOJ was an active buyer of JGBs as part of its quantitative easing program (keeping longer-term rates from rising).


So why am I bullish on Treasuries in 2009?  To be clear I am not arguing for much more upside, just against the notion of lots of downside – 2008 was the year of crashing Treasury yields and 2009 will be the year of low yields.


On the question of low US savings, this is yesterday’s behavior.  The threat of losses in income from unemployment and losses in wealth from falling home and stock prices will make for a Japanization of the American consumer relatively quickly – ask a retailer, ask a restaurateur, ask a hotelier, ask a bond trader…  And if these anecdotes are not convincing look at the data from chain stores, Commerce and sentiment index publisher.  And look at GDP.   


Foreign investors may flee Treasuries as the Fed prints money and the government borrows its way to prosperity.  Foreign official holders of US Treasuries are not likely to flee…like China despite its verbal posturing today over a subtle warning that US officials should not take for granted ever rising Chinese demand for US government debt, particularly if the policy mix becomes unacceptably risky.  China can’t sell – mutually assured financial self-destruction principle holds.  China has to buy – China’s economy is not going to switch from export driven to domestic demand driven overnight and maintaining a competitive yuan necessitates amassing foreign currencies and hence debt denominated in foreign currency. 


Still some selling of US debt by foreign private and public holders is inevitable (GSE debt has seen foreign official accounts dump it for US Treasuries in the last four months). 


I see two sources of demand for Treasuries that should offset anything short of a wholesale exit of US debt by foreign holders (again a world where there would be nearly no winners).  Like in Japan, US banks can borrow Fed funds at zero and buy 30-year debt and pick up 262bps which will do some of the heavy lifting in restoring bank capital.  And like in Japan, the US central bank will be a buyer of Treasuries (amounts to be determined).  I think the lesson of the last 16 months is buy what central banks like the Fed are going to buy. 


And I have problems with the bond bear timelines for recovery and inflation. 


First of all every prior recovery, outside of Japan’s lost decade, any of us have seen in the last 55 years has come with a banking system fully intact and operating as a credit creation machine (taking in deposits and making loans).  That machine, outside of healthy (smallish) regional banks, is now broken.  Japan’s banking system was broken too and was a key reason why the policy mix was so hopelessly ineffective in bringing deflation to an end.   Without a banking system acting as a transmission mechanism for credit to reach households and firms, central banks and governments are at a distinct disadvantage in using monetary and fiscal policy to spark consumption and investment (something that should only be done in periods of extreme downside risks).  Hence the zero rate bound and quantitative easing alternative is in response to a broken banking system (caused by it – liquidity trap).  In Japan the BOJ wrongly stuck with the banks as the primary transmission mechanism to create credit when there was no chance the banks would invest in anything other than risk free government bonds.  The Fed, aware of this shortcoming, is doing an end run around the banks as it embarks on quantitative easing, buying securities (of all sorts) from the market directly (biggest problem for the Fed is that the non-bank credit creation machine is too small for the job which argues in time for the Fed directly providing (or guaranteeing) credit to the private sector. 


My point is that the Fed has no fairy dust to sprinkle on the economy and bring it rushing back to life and back closing the output gap.  Even with the knowledge of how not to repeat Japan’s errors, the Fed (and US government) will need lots of time before policies have the desired effect.  Selling bonds today for an outcome that might take five years to unfold is not the best timing.  Bond bears want to go short just as the recession has gone from bad to very worse – no trough in sight and no recovery imaginable for a few years at the soonest.  And a similar story plays out for price level developments – selling bonds before deflation risks have been thwarted (drop in energy prices assures that headline inflation will run negative in Q1) mush less before disinflation has peaked. 


Printing money is a necessary but not sufficient condition to higher Treasury yields much less inflation and inflation expectations.  Again see Japan’s experience.  Bond bears are guilty of skipping stages.    


Jim Grant would have everyone believe that the US government debt is not worth the paper it is printed on – a conclusion he reached years ahead of the current recession and financial crisis.  As much as I like and respect Grant, the chance of a credit rating agency downgrading US government debt in the next few months (try my lifetime) is zero…okay maybe credit ratings are not what they are cracked up to be.


I would also note that in the dollar’s plunge last week which many pinned on the Fed’s ZIRP and QE (monetization or running printing press ahead), Treasury yields went to 50-plus-year lows…in Zimbabwe where printing presses run night and day, I suspect government debt is as worthless as the ZWD…they go hand in hand.  I will worry (much later in the crisis) when bond yields and the dollar are moving in lockstep (bond prices and dollar down).  Until then I think the Treasury sky is not falling.  Will it never fall?  I tend to think it won’t.  But I am also not suggesting that in the coming months and quarters that bond prices and the dollar won’t sell-off some.  But I doubt it will happen because of a wholesale rejection of US liabilities (bonds and the dollar). 


And as far as the business cycle is concerned, the data suggest the risk of disinflation becoming entrenched deflation is growing.  Housing data for November, out earlier today, were dreadful…no bottom in sight.  Retail sales are…not even worth the effort.  Household wealth is depressed (stocks down 40% from November 2007 highs and home prices still falling).  Corporate profits are collapsing.  Global trade is slowing rapidly.  Firms and households with high levels of leverage (debt) are at serious risk of default, bankruptcy.  Again the banking system is broken.  Oil is under $40 a barrel and falling and there is no talk of speculators shorting the market.  This is not the time to put on trades based on a crisis in confidence in US government debt and the dollar. 


So I am not calling for major new upside in Treasuries (prices) in 2009, just not a lot of downside. 


Where I see upside is in instruments the Fed and Treasury will be buying – GSE debt and GSE MBS, munis and higher quality ABS more generally.


David Gilmore



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