We are living in strange times. U.S. interest rates are close to record lows - in fact, the 10-Year U.S. Treasury Bond yield [(NYSEARCA:TLT), (NYSEARCA:SHY) and (NYSEARCA:EDV) can be used as a way to invest in U.S. Treasuries] hit a 220-year record low during the summer of 2012. Consequently, chatter about an impending implosion of the U.S. government bond bubble has increased to deafening volumes.
Despite the rhetoric, I believe there is enough evidence to support the argument that U.S. Treasuries may trade sideways for a long time. I am not necessarily advocating the allocation to U.S. Treasuries. I am, however, attempting to cool the fire currently burning under Treasury investors' feet. Yes, perhaps Treasuries won't provide a decent yield and may lose some principle over time (unless held to maturity), but the commonly-held belief that U.S. Treasuries will imminently collapse may be unfounded.
Let's look to Japan (NYSEARCA:EWJ) as a basis for comparison.
The chart below shows the yield on Japanese government bonds (NYSEARCA:JGBS) dating back to the mid-1960s. Like the U.S., Japanese yields have declined consistently (except for a reversal in the early 1990s) since the early 1980s. Around 1999, yields fell to less than 1%. All the while, many macro hedge fund managers around the world lost money shorting Japanese government bonds, thinking yields had bottomed.
Even since the general decline in yields seems to have finally ended, Japanese yields have oscillated within a narrow trading band ever since - a 15-year flatline (see second chart below). In fact, this trading position has humiliated so many hedge fund managers over the past couple decades that it is commonly known as 'The Widowmaker Trade' (Kyle Bass discusses his current version of this trade). After a 15-year bottoming process and a change in attitude toward inflation, if any major government bond market is poised for imminent collapse it is Japan's. The U.S. has years (if not decades) before it starts to look like Japan.
30+ Years of Falling / Low Yields
The 15-Year Flatline
U.S. Treasuries too have experienced a 30-year decline in yields, as seen in the chart below. Today (and over the past few years, to be frank), many investment managers are calling for a collapse in the Treasury 'bubble'. While a reversal of a 30-year directional trend makes intuitive sense, the Japanese experience should make any interest rate forecast an exercise in modesty.
30+ Year Decline in U.S. Treasury Yields
Looking specifically at the time that Japanese government bond yields started moving sideways (chart below), you can see that U.S. Treasuries have only spent the time closing the gap. Based on the Japanese experience (not that any of this has to happen to the U.S.), U.S. Treasury yields aren't setting any worldwide records. If JGBs can fall into the <1-<2% range for 15 years, why can't the bonds issued by the controller of the world's reserve currency?
Comparing the 15-Year Yield Experience
Japan is in far worse shape than the U.S. As you can see in the chart below, the Japanese government debt-to-GDP ratio has skyrocketed to the 200%+ range. In comparison, while uncomfortably high, U.S. government debt-to-GDP has only just broken 100%. If the U.S. isn't the preferred borrower, then I am living in bizarro world.
Who Would You Lend to?
Of course, debt accumulation is a function of spending. While the U.S. is no stranger to massive deficits, Japan clearly has consistently spent more money that it has earned. Again, the preferred lender in this case would be the U.S. So if Japan can maintain record low yields for 15 years all the while running a black-hole deficit why couldn't the U.S.?
Deficit as a % of GDP
And the grand finale, which could also double as the prelude, is Japan's productive capacity relative to its dependent population. Japan's employment-to-population ratio has fallen consistently since the 1970s, precipitously so since the Nikkei peak around 1990. The U.S. is catching up, but has benefited from a structurally sounder population (and tax) base since around 1995. I ask again: given a structurally weaker economic framework, why can Japan support rock-bottom yields for 15 years but the U.S. cannot?
Who is Paying the Bills?
Alas, assessing the U.S. Treasury 'bubble' isn't simply about comparing it to other countries, although this what many bond investors do.
We must also consider who owns U.S. debt, who is buying U.S. debt and what motivates these buyers.
Currently, U.S. entities own about 2/3 of all debt issued by the U.S. government. This includes a large captive audience such as the Federal Reserve, Social Security and government pension funds. The Federal Reserve in particular has stepped up since the financial crisis and has, at times, been the overwhelming buyer of U.S. government debt, indirectly monetizing new issues. Consequently, the Federal Reserve has increased U.S. Treasury holdings from about 4.7% in March 2009 to almost 11% at the end of the U.S. government's fiscal year in 2012.
While the Federal Reserve has profited nicely from its U.S. Treasury holdings over the past few years, unlike most investors it is not driven by a profit motive. The Federal Reserve is attempting to control interest rates through open-market operations, and it has done so successfully. How high would the Federal Reserve allow yields to rise? With unemployment close to 8% and low-single-digit GDP the 'recovery' is still very weak. Therefore, the tolerable yield level is likely quite low. Any breach beyond this threshold - especially if it started to impact the real economy - would be met by aggressive Fed monetary expansion.
This means that if yields begin to rise beyond a threshold deemed acceptable by the Federal Reserve, it will step in to buy them on the open market. And with the ability to print U.S. dollars the Federal Reserve has the infinite capacity to do so.
In other words, it is irrelevant that the yield on U.S. Treasuries may not entice the average Mr. Smith to hold a bond mutual fund. The Federal Reserve, and the banking system that it monopolizes, has the infinite capacity to offset selling pressure and/or lack of demand.
Finally, some are calling for a collapse of U.S. Treasuries brought on by big foreign holders like China (NYSEARCA:FXI) (owns 8% of U.S. Treasuries) and Japan (owns 7% of U.S. Treasuries). While I won't discard this as an eventual possibility (in fact, it could be a long-term geopolitical strategy for China...but the risk isn't imminent), I don't think most major foreign holders of U.S. Treasuries are anywhere near being motivated to sell. Let's face it, Japan, China and the U.S. import-export markets are interlinked and neither country has any interest in seeing the U.S. dollar depreciate any faster than it already is. Foreign U.S. Treasury ownership and global trade is trapped by interdependencies. For the moment, 'change nothing' is the likely strategy for all parties.
U.S. Treasuries aren't an attractive investment. I wouldn't be happy lending my hard earned money for the current yields on U.S. Treasuries. I also think U.S. Treasury yields have little room to continue falling, so the capital gains potential is likely capped. Despite this, comparisons, precedents and motivations tell me that there is no need for investors who own U.S. Treasuries to run for the exits...yet.