United States Treasury Bubble?

The market has completely panicked. The DOW fell -265 points on August 2nd, 2011 and -512.76 August 4th 2011, as investors fled stocks and put their money into government backed securities like short-term and long-term treasury’s.

The fear of a debt default, which was completely unfounded (politicized by Obama and Geithner), has been eliminated now that the debt ceiling has been increased and the government has the authority to borrow more money. At the same time, the economy appears to be heading towards a double dip recession as the entire year of 2011 had its GDP numbers revised downward. In addition, manufacturing data, unemployment, and the dollar’s value are all getting worse and there doesn’t appear to be any positive momentum to reverse these numbers.

This makes investing a very risky business. Should one invest in stocks that can fall precipitously due to an economic downturn? Or invest in treasury’s that have virtually no chance of default but yield little return? Well, it seems to be the latter.

Investors dumped their stocks and mutual funds today in a show of panic against a failing economy. Left with little options, they turned to treasuries and gobbled them up. This caused a rapid decline in treasury yields such that the short-term and long-term yields are now at historic lows, much lower than the rate of inflation.

As people invest in treasury’s and drive the bond prices up due to demand, the yield rates go down. For example, a 10-year treasury has a yield of 2.35%, much lower than the rate of inflation which currently sits at about 3.5% as of June 2011. Despite this, investors apparently feel it’s worth the guaranteed loss on their investment due to inflation, rather than risking the chance of losing a lot more by investing in the stock market when a substantial amount of data suggests we are heading towards a double-dip recession.

But here’s the problem … when, not if, inflation rises higher than where it is today (or maybe 15% like it did during Jimmie Carter’s era back in 1979), no one is going to want those 2.35% treasury yields. Anyone left holding these treasury’s will have two options; sell them for an extremely discounted rate, or hang onto them to get their principal back plus a measly 2.35% interest. Treasury investors could suffer major losses due to the eroding economics of an inflationary money policy. This could very well lead us down a path towards a “treasury bubble”.

When this happens, many people will lose a lot of wealth due to inflationary forces. Those who invested in the treasury’s will find they only produced about a 2.35% return on their investment. But with inflation much higher, the buying power of their money will have been eroded. What used to cost $4.00 may cost $5.00 in just a few years time, but they only have $4.10 of buying power from their treasury investment.

Indications right now show that inflation is stable. It’s not spiking and it’s been fairly consistent over the last decade staying below 5%. But the Federal Government has also borrowed, and the Federal Reserve has issued, a tremendous amount of money during this time that has yet to make its way into circulation, due in part to large businesses and banks holding onto cash for fear of market uncertainty and new costly regulations. It’s estimated that large corporations have a couple trillion dollars sitting on the sidelines. President Obama has borrowed more in 3 years than President Bush did in all his 8 years combined. By introducing trillions of new dollars into circulation through government borrowing and Federal Reserve issuance, price inflation is inevitable. The question becomes, how bad will inflation get? The graph below doesn’t reflect the recent approval to increase the debt ceiling by an additional $2.4 trillion dollars.

So, when inflation kicks and if it goes above 5%, I think we could see investors back away from treasuries. This will lower demand, thus lowering treasury prices. Conversely, treasury yields will increase making it more expensive for the government to borrow money, but will entice new investors. As mentioned before, those who invested in treasury’s with super low yields at 2.35%, won’t be able to sell them and a lot of people will lose a lot of money.

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