Will the dollar, and treasuries collapse?
December 11, 2008
There appears to be a belief now that the dollar is going to collapse rather soon, driving the US Treasury bond interest rates to higher levels. There’s also a lot of speculation that there’s a bubble in Treasuries.
It’s true that there’s a bubble in Treasuries. Negative interest rates, or zero interest rates are simply too low to be justified by the fundamentals of the US economy, and it is true that the dollar must eventually lose much of its value in order to allow the US economy to find a balance.
On the other hand, bubbles can run for longer periods than people expect them to. Irrational valuations can deteriorate even further if the conditions that sustain the bubble persist.
In that sense, we must ask ourselves: What is there in the world, today, other than Treasuries that can suck out the uncommitted dollars in the system, and allow the global economy to breathe? That the stock markets are incapable of doing so is obvious, as there’s too much uncertainty, at this stage, to allow this. Commodities are unlikely to appreciate much, unless emerging markets return to their growth path, but they can’t do so without US demand coming pack, which will not happen for many years. Gold is a speculative instrument tied to commodities, and it’s hard to hold it in very large quantities. The money flows that sustained its rise over the past few years, such as Asian exporter money, and Middle-Eastern, or Russian petrodollars, are blocked. The Euro cannot gain much value, because the ECB, despite its hawkishness, is likely to be forced to follow the rest of the world as financial conditions deteriorate: Eurozone banks are no less leveraged than their US counterparts.
On the other hand, dollar demand is no less urgent than before. While libor values may have eased somewhat, the fundamental factors that force financial actors to hoard dollars are still powerful: Deleveraging is continuing in the West, Asian firms are facing bankruptcy, and many firms are facing great difficulty in the finding the dollars to meet their obligations. Of course, as we see at the moment, there’re periods of relaxation, but the underlying theme is as alive as ever, and it is premature, therefore, to speak of the demise of the dollar until the real impact of the global stimulus is seen. At the moment, it’s still unclear if it will be of much help, because of the global nature and scale of this crisis.
The rally in Treasuries that pushed yields on bills below zero percent this week is adding to concerns that the $5.3 trillion market for government debt is a bubble waiting to burst.
Investors seeking safety from losses in equity and credit markets charged the Treasury zero percent interest when the government sold $30 billion of four-week bills on Dec. 9, the same day three-month bill rates turned negative for the first time since the U.S. began selling the debt in 1929. Yields on two-, 10- and 30-year securities touched record lows this month.
“Treasuries have some bubble characteristics, certainly the Treasury bill does,” said Bill Gross, co-chief investment officer of Newport Beach, California-based Pacific Investment Management Co., which oversees the world’s largest bond fund. “A Treasury bill at zero percent is overvalued. Who could argue with that in terms of the return relative to the risk?” he said in a Bloomberg Television interview yesterday.
The 30-year bond returned 23.6 percent since September, including reinvested interest, more than it earned in any one year since gaining 34.1 percent in 1995, according to Merrill Lynch & Co. index data. Treasuries of all maturities gained an average of 11.9 percent this year, compared with a 41 percent drop in the Standard & Poor’s 500 Index and a loss of 15.3 percent in Merrill Lynch’s broadest corporate bond index.
Rising supply of government debt to pay for the bailout of the economy and financial system has done little to damp demand. Treasury Assistant Secretary Karthik Ramanathan said in a speech yesterday in New York that the U.S. may introduce new financing methods to meet borrowing needs of $1.5 trillion to $2 trillion in the financial year that ends in September.
While supply has increased, rates on three-month bills fell 2.89 percentage points in the last year to 0.01 percent today, after trading as low as negative 0.05 percent on Dec. 9. The rate on four-week bills plummeted from a peak of 5.175 percent on Jan. 29, 2007. The three-month bill yield was unchanged today.
An investor who bought $1 million in three-month bills at the closing rate of negative 0.01 percent on Dec. 9 would realize a loss of $25.56 when the securities mature. Bills are sold at a discount and appreciate to par at maturity.
Even at the low yields, the government received bids for four times the amount of four-week bills it auctioned this week, according to the Treasury.
“There is basically insatiable demand for Treasury bills,” Ira Jersey, a New York-based interest-rate strategist at Credit Suisse Group AG, said in a Bloomberg Television interview. “There is a number of reasons for this, not only angst over deflation and what’s going on with risky assets, but there is also just a lot of cash that does not want to take any credit risk.”
Hunger for Treasuries increased as financial companies reported $984 billion of losses and writedowns related to the collapse of subprime mortgages since the start of 2007. The losses froze credit markets and helped send the U.S., Europe and Japan into the first simultaneous recessions since World War II.
Gross said he regrets not buying Treasuries in the past year. “If we went back 12 months and we had known then what we know now, it would have been all invested in Treasuries,” he said in the interview.
David Rosenberg, the chief North American economist at New York-based Merrill Lynch, said last week that demand for Treasuries had reached the “bubble” phase like in technology stocks in 2000 and real estate six years later.
Record-low yields on government debt have led money-market funds to waive fees to keep returns positive. If the Federal Reserve cuts its 1 percent target rate for overnight loans between banks, as is expected next week by all but two of 56 economists surveyed by Bloomberg, some Treasury fund returns may turn negative, said Peter Crane, president of Crane Data LLC, a research firm in Westborough, Massachusetts.
Sentiment among investors in Treasuries turned negative for the first time in four months, according to a JPMorgan Securities Inc. survey of clients. The firm’s weekly index fell to minus 6 on Dec. 8, from this year’s high of 27 a month ago. The figure is the difference between the percentage of investors betting prices will rise and those expecting a decline.
Speculation that the recession will result in deflation, or a prolonged slide in prices, is also driving demand for Treasuries. Consumer prices fell 1 percent in October, the most since records began in 1947, and may drop 1.2 percent in November, according to a Bloomberg survey of economists.
Deflation may worsen the economic downturn by making debts harder to pay and countering the impact of Fed rate cuts. Deflation also makes bonds more valuable, even with yields at record lows.
Treasuries may actually be “fairly valued,” Tony Crescenzi, chief bond strategist at Miller Tabak & Co. in New York, said in a report yesterday. Even so, yields will likely rise in mid-January as investors’ focus turns to prospects for an economic recovery, he wrote.
The U.S. pledged $8.5 trillion, more than half of the country’s gross domestic product, to spur lending and limit the damage of the recession.
Economists forecast higher bond yields as those efforts take effect over the next year. The yield on the 10-year note will rise to 3.66 percent by the end of 2009 from 2.67 percent today, according to 50 estimates in a Bloomberg survey. That would result in a loss of 3.88 percent as bond prices decline.
“At some point we are going to get some signal, some indication that this massive policy response is getting some traction,” said Mitchell Stapley, who oversees $22 billion as chief fixed-income officer for Grand Rapids, Michigan-based Fifth Third Asset Management. “The flight out of Treasuries is something that will be breathtaking.”