The bear case for Treasuries seems overwhelmingly powerful. With a median forecast for the budget deficit of 9.9% of GDP this year and 9% in 2010, supply will continue to be huge. The amount of Treasuries outstanding therefore continues to rise, likely to reach 100% of GDP in the coming year. The average maturity of this debt is quite short - under 4 years - so as well as sales to finance the deficit, new bonds have to be issued to refinance maturing ones. The sheer volume of bonds that need to be bought is terrifying.
There is then a question of value. Yields of 0.7% on two year, 2.1% on five year, 3.4% on ten year and 4.4% on thirty year bonds represent poor value when looked at historically or on a total return basis. After tax and inflation an investor is likely to receive almost no return. And if interest rates go up as expected next year yields will rise sharply. When the Fed raised rates in 1994 ten year yields quickly rose by over 2%, the same around the beginning of Fed rate increases in 1999. In 2004 the response was smaller, but yields still rose over 1%. A rise in yield of 1% causes a drop in price of over 8% on a ten year bond, 16.5% on a thirty year.
There are also worries about where demand will come from. China and Japan are by far the biggest holders of US Treasuries. As of September China held USD798.9bn of US Treasuries (up from 618.2bn a year previously), Japan 751.5bn. In China's case it is a spin-off from their currency policy. In order to stop the Yuan appreciating against the dollar they have to buy dollars which they then park in Treasuries. As they move towards a more flexible exchange rate system or their trade surplus declines the need to buy Treasuries will diminish. Japan is even more worrying. With a large budget deficit of its own Japan has up to now had sufficient domestic savings to finance its JGB issuance. But as its population ages and thus saves less Japan may need to sell Treasuries to support its own bond market.
So Treasuries are an investment which offers a poor yield, are vulnerable to losses in the expected environment, are in constant and abundant supply, and whose historical buyers are increasingly questionable.
So why aren't yields steepling higher already?
The answer has two dimensions. First, there is the current alternative. Leaving aside risk assets the choice faced by portfolio investors is to hold cash earning nothing or bonds earning 2, 3, 4%. By extension banks can borrow at close to zero % and earn the 2, 3, 4. So while interest rates remain low, as the Fed promises investors will be the case for an extended period, there is easy money to be made in an expensive asset.
The second dimension is what the consequences will be of a sharp rise in yields. With the economy structurally weak and the budget deficit so high a rise in yields is likely to have a significant dampening effect on growth, and on the already weak fiscal position. This is the reason why the Fed continues to talk the prospects of rate rises down. If policies are implemented to try to improve the fiscal situation then there will be a strong need to keep interest rates low to offset the fiscal drag.
So unless the economy develops enough internal strength to allow both fiscal and monetary tightening interest rates are going to be low on a multi-year horizon and it makes sense to own expensive bonds rather than cash.
One final observation. There are very few bond bulls out there. Most institutional investors I know are underweight bonds as an asset class and underweight duration in dedicated bond portfolios compared to benchmarks. Most are overweight corporates vs Treasuries and the circus is back in full swing on the credit side with CDOs, PIKs, covenant lites, CoCos etc all back. A recurrence of problems in the credit markets will provide strong support to government bonds.
So although the bear case is highly persuasive - buy Treasuries!
Disclosure: Long Treasuries and other government bonds