Monday, December 01, 2008

Treasury Rates: Less than your bargained for

T-bills at zero? 2-year notes less than 1%? 5-year notes less than 2%? Locking up your money for 30-years at 3.30%?

If these yields make it sound more like you are donating your money to the Treasury rather than lending it to them, you aren't alone. People are going to struggle to buy anything at such low yields.

But your normal precepts about interest rates are not going to hold in a ultra-low inflation (or possibly deflationary) environment. Be careful reflexively assuming that one should short rates at these levels.

Be especially careful taking your bond allocation into cash at this point. Money market rates are much more likely to fall than to rise. Currently fed funds futures predict an 64% chance that the Fed will cut to 0.5% on December 16, and a 36% chance they will cut to 0.25%. Recently, J.P. Morgan joined UBS and others expecting the Fed to cut all the way to zero eventually. At that point, 2% on 5-year notes won't seem so ridiculous. And the odds are good that short-term rates will stay low for a long time. So holding cash waiting for better yield opportunities isn't likely to be a winning strategy.

In addition, consider the diversification effect. For most investors, bonds are meant to be an offset to riskier allocations. When stock prices fall, Treasury prices tend to rise, helping to at least stabilize one's portfolio to some degree. If stocks continue to fall, cash rates are all the more likely to got to zero. If stocks rise, you won't be complaining about money lost on intermediate bonds!

Of course, ultra low rates hurt income oriented investors the most, such as someone already retired. Those investors really should be looking away from Treasury bonds at this point anyway. 5-year Treasury rates might only be 2% but five-year non-call Agency bonds are still north of 2.75%. For that matter, 5-year municipal bonds are still available at 3% tax free. Agency-backed mortgage bonds carry yields over 5%. These are all sectors where buy-and-hold investors should be able to find bonds with minimal credit risk, and can therefore ignore periodic marks and just collect the income.

So when you see interest rates hitting all-time lows, remember that the U.S. hasn't faced this confluence of deflationary forces since the Depression. Investors are going to need to adjust their expectations about interest rates accordingly.


viking said...

yep, that's what happened last time

in the depression

except we were a creditor nation then

we won't be able to keep rates low this time

we already owe too much

PNL4LYFE said...

How would you weigh the deflationary forces of deleveraging against what I believe is inevitable dollar weakness in the future? Given that base case, I've been trying to figure out what is worth buying. Perhaps a basket of foreign currencies, although I don't know enough to know which ones will have the same problems we have. Or gold, but if things truly get dire, demand for "consumption" (jewelry etc.) must decline. Or maybe ag commodities, although they may fall if demand growth for high-intensity products like beef subside in emerging markets. Basically, I'm at a loss; I have been relatively content sitting mostly in cash, but every day that goes by makes me less confident holding IOUs of the U.S. government.

Alternatively, is there a compelling argument for bullish long term prospects for USD? I think the recent rally is a 'least of many evils' rally and from technical demand. Is it possible that this is sustainable?

Accrued Interest said...

I think of currencies in terms of interest rate differentials. And its easy to see the ECB and BOE's target rates falling much more than the Fed's. Therefore you could see the dollar continue to strengthen.

Now that being said, I'm not personally taking a position on either side of the dollar. I'd probably rather be short than long if forced to choose one.

But think about a dollar collapse. I mean a real collapse, like the U.S. can't pay its debts. What do you want to own there? Is everything going to be hunky dory in China? Or France? Or Brazil? Or Germany? No. The world will be SOL. I mean, even owning gold won't work unless you physically hold the bars.

Anyway, another way to think about the increasing Treasury debt is that deleveraging involves the elimination of debt. The Treasury is ramping up its borrowing at a time when the private sector is increasing savings.

santcugat said...

I don't think the great depression is a particularly good comparision.

If you really wanted to make the comparison, China would make a better stand-in for what America was during the 20s... big manufacturing power, big creditor.

The strict adherence to the gold standard at that time also meant that Ben's helicopter fleet would never have gotten off the ground.

Is it possible that there is a bubble in long term treasuries?

cyclicalorsecular said...

The US Gov't is replacing private balance sheets (which will soon include pension funds and state/municipal governments) with its own. As viking notes, that is fine when we have balance of payments surpluses, but we don't and haven't for 50 years. The world's economic engine post-WWII was driven by a persistent and growing US current account deficit. Now that that finally seems unsustainable, what happens? Can we collectively ease off and gently devalue the USD as the world reserve currency or will that too fall off a cliff, as have all other asset markets and currencies of late?

And I agree with the China as a correllary to the US in the 20s. I think China keeping an artifically weak currency can be seen as trade manipulation, a la Smoot Hawley, but in disguise. That will somehow need to be addressed, and hopefully not through isolationist policies.

PNL4LYFE said...

AI: Hasn't much of fall in European rates been priced in? Their curves are flatter, but long rates are already quite low. Regarding a dollar collapse, your point is well taken that it is difficult (and pointless) to hedge against armageddon. But isn't inflation/dollar weakness the only way out from under our mountain of debt and future unfunded liabilities? We won't actually default, but we will pay back the world with devalued dollars. Or do we eventually reach a point where we can't roll our debt in our own currency?

Sorry for being so cheerful on a Monday...

Bobby and Jean the amateur world travelers said...

remember in deflationary times...

real interest rates at ZERO are still net POSITIVE.

So if deflation rates are 3% (-3% inflation) and rates are at 0%, income investors can sit in cash and be yielding 3% on their purchasing power.

just a thought not all doom and gloom.

Oh don't count the the world losing their appetite for our debt either.
unlimited taxing authority, it is very doubtful we will default.

also if we expect something to happen, it won't happen.

Lockstep said...

AI, in what horrible and unlikely scenario would you see the Treasuries abandoned by foreign governments?

Was the Fannie and Freddie debt crisis in July a prelude to what could happen now that we want to artificially decrease long bond yields?


Accrued Interest said...


It isn't impossible for foreigners to abandon US Treasuries, but they'd have to have someplace else to go. Currently I see UK, France, Germany as having similar problems in their banking system. Japan already has unattractive yields. So where is China going to invest their reserves if not America? Beyond the G7, no other country is even remotely large enough to take China's deposit.