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Should one invest in United States Treasury bonds?

Even with the low yields that exist in today's financial markets this is perhaps one of the best investments you can make in terms of return…when there is very little risk associated with the investment.

And, the risk that is associated with these yields is not that of default, but the risk that interest rates will begin to rise and bonds prices will collapse.

And, what will cause interest rates to rise? The answer is, a more robust economic recovery.

So the question is, what is the possibility that the economy will begin to grow more rapidly which will then put more pressure on price. This is the economic reason that interest rates would rise…and rise quite rapidly.

Well, there are two reasons to say that this is not going to happen in the near term. The first reason is that the economy is just not in a position to begin growing rapidly soon.

The Federal Reserve has signaled that it does not believe that a stronger economic recovery is around the corner. Federal Reserve officials have stated that short-term interest rates will probably be kept low into 2014. Some analysts think that these rates will remain quite low for an even longer period.

Thus, slow economic growth coupled with an easy monetary policy is not a recipe for rising levels of interest rates, both short-term rates as well as long-term rates.

The other reason is that it seems as if the Fed's efforts to flood the economy with liquidity is having an impact on financial assets but not on the production of real assets. I have written about this in terms of the return of credit inflation and the absence of price inflation. The argument here is that credit inflation is a result of easing monetary policy where the money injected into the economic system primarily remain in the financial sectors of the economy with very little spill-over into the "real" part of the economy.

Over the past twenty years or so, this has been what has happened in the United States economy. During this time period credit grew at a very rapid pace. Yet, prices inflation was so gentle that the earlier part of the period has been called the "Great Moderation."

This period of credit inflation is expected to continue for some time. As a consequence, however, Mohamed El-Erian, the chief executive officer of PIMCO, states, "Investors should recognize that in virtually every single market segment we are trading at very artificial levels."

Or, as Bill Gross, the co-founder of PIMCO, explains it, "Almost all asset markets are bubbles and mispriced." This situation is a result of monetary experiments by the Fed and its peers in Japan, the UK, and Europe.

The issue then becomes, where does one put his/her money? Short-term money market funds are not the answer because they are only paying out about 20 basis points as a return. The 10-year Treasury yield is only about 1.70 percent right now, but this instrument bears no credit risk and if economic growth remains anemic then there is little or no risk.

In terms of risk and return, Mr. Gross argues, there little better tradeoff available.

One might add, however, in 2011 Mr. Gross was on the other side of the argument. At the time he believed that the Fed's monetary ease was going to be reflected in stronger economic growth…but it was especially going to be reflected in higher rates of price inflation.

The decline in the yield on the 10-year Treasury issue to 1.70 seems to be related to a decline in the financial markets' estimate of what the inflation rate should be. Up until the past week, the inflationary expectations built into the 10-year Treasury yield was in the neighborhood of 250 to 260 basis points. Currently, these inflationary expectations have dropped into the 230 to 235 basis point range.

This drop in the inflationary expectations built into Treasury bond yields coincided with the drop in the price of gold last week, another indicator that investors were coming to believe that there would be less price inflation coming in the future.

People and businesses are not spending on goods and services that are produced. That is, they are not taking the money the Fed has injected into the economy and rushing out to buy consumption goods and investment goods. They are holding onto the cash, or, they are buying assets, both financial and real, like housing. Asset prices do not enter into the calculation of the cost of living as defined by the Consumer Price Index or other similar measures.

Thus, economic growth remains tepid and credit inflation expands. And, bond prices do not fall.

Mr. Gross argues presents two possible scenarios, given the current environment. "If you're going down this Armageddon trail, you can either have an inflationary bust, or you have a deflationary bust, as in a depression."

Currently, "neither scenario is quite imminent, yet."

So, US Treasury bonds seem to be a good investment for the time being. That is, the bull market in Treasury bonds continues, the bull market that has been going on since the early 1980s.

If you feel that the yield on these investments are too low, well you can "goose up" your returns. And, the way to "goose up" the yield on your bond portfolio is to use leverage and to gain even more return, use short-term debt to purchase your long-term debt.

This is exactly the behavior we saw during the credit inflation in the United States, which extended beyond the last forty years of the 20th century. If you don't want to take on riskier assets, then to increase the yield of your portfolio, just increase the leverage you use in your portfolio and buy long-term assets using short-term liabilities.

The only thing we see missing here is a discussion of financial innovation, which also tends to accompany credit inflation. My belief is that this time around we may see more innovation in the make-up of financial institutions than in the past fifty years and see less innovation in financial instruments. Right now, the "shadow banking" space has grown to the point where it is about the same asset size as the "banking" space. In the next ten to fifteen years, my guess is that the "shadow banking" space will be at least twice the size of the "banking" space.

For all the changes mentioned in this post we have Mr. Ben Bernanke and the Federal Reserve System to thank! Welcome to the brave new world of finance.

Source: Invest In U.S. Treasuries