Treasury Bubble Redux

Last week, while everyone was busy gawping at the stock market’s wild swings and oil’s epic fall from grace, we set our sights on the 10 Year Treasury note.  On Thursday and Friday the yield touched down at 1.75 percent.  Yields haven’t been that low since May 2013.

What’s more, 10 Year Treasury Yields are approaching their all-time low of 1.53 percent that was briefly reached in July 2012.  If you recall, when Treasury yields go down, Treasury prices go up.  In other words, right now Treasuries are nearly as expensive as they’ve ever been.

With global financial markets being on edge, U.S. Treasuries appear to be a safe bet.  “They’re the safest investment in the world,” goes the popular wisdom.  Many investors reason they are guaranteed the return of their principle, plus 1.75 percent to boot.

Here at the Economic Prism we believe 1.75 percent is just enough rope for people to hang themselves with.  But don’t listen to us.  We’ve been predicting a debt market reversal for at least six years…possibly longer.

Still, you have to admit, our rationale is rock solid.  You see, the market for government debt is mostly boring most of the time.  But occasionally it reaches an inflection point.  That’s when it explodes…

High Peaks and Wide Valleys

Perhaps now an inflection point is being reached.  Unfortunately, we won’t know for sure until after it has come and gone.  Here’s why…

Interest rate cycles span long periods of time…often they last between 25 and 35 years.  For example, U.S. Treasury yields reached a peak in 1920.  Then they slowly slid down a soft bunny slope, bottoming out at about 2 percent in the early-1940s.

After that, they rose again – along with inflation – for a long, long time.  By 1980 it seemed yields would go up forever.  In fact, about this time, Franz Pick famously declared that “bonds are certificates of guaranteed confiscation”.

What Mr. Pick didn’t realize at the time of his declaration is that an inflection point had been reached.  For in early 1982 yields again ventured over the mountain and slid down a soft ascent to historic lows in July 2012.  Since then, they have skidded along the bottom…and the Federal Reserve is determined to keep them there.

Zero Interest Rate Policy (ZIRP) is well into its sixth year.  This may change later this year.  Regardless, raising the federal funds rate from practically zero to 0.5 or even 1 percent is absurdly low by historical standards.  Plus there are limits on what the Fed can really control…

Treasury Bubble Redux

The notion that the Fed’s in control of mid- and long-term interest rates is utter nonsense.  At one time they may have been.  But after economies went global, yields on government debt became more about trade deficits and the petro dollar.

At the moment, both trade deficits and the petro dollar are transitioning away from how they’ve behaved over the last 30-years.  If things continue this way, yields could finally be commencing their long awaited 40-year trudge up Mount Everest.  Why now?

Over the last 40 years, with the support of an abundance of cheap Fed credit, public and private debts exploded.  This debt explosion expressed itself in the form of massive trade deficits.  The U.S. as a whole imported more than it exported.

In return for all these imports, the U.S. exported an abundance of paper dollars to pay for oil and cheap plastic goods.  Oil producing nations, like Saudi Arabia, and producers of cheap consumables, like China, took the excess of dollars, converted them into their local currency, and then recycled them back into U.S. government debt.  This had the perverse effect of artificially suppressing their currencies while artificially propping up the dollar.  It also pushed Treasury yields down further and further.

But things may be changing.  The November 2014 U.S. trade deficit fell to $39 billion, which is an 11 month low.  This was largely aided by a decline in oil imports…now at a 20 year low.  The November trade deficit with China also dropped 8 percent.

For now, U.S. Treasury yields continue to be pushed down by investors seeking stability during increased market volatility.  However, when things moderate, a declining U.S. trade deficit could be the tipping point.  It could reverse the 40 year trend of declining interest rates.

If so, the great U.S. Treasury bubble would finally burst.  Instead of credit becoming cheaper and cheaper it will become more and more expensive.  Asset prices will have to adjust – drop – accordingly.  It will also pinch economies the world over.  They’ve grown dependent on the explosion of cheap credit.  Take it away, and disaster will follow.

Sincerely,

MN Gordon
for Economic Prism

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