Don't Get Caught in the Treasury Bond Trap

Includes: GLD, SLV, TIP, TLO
by: Mike Scully

U.S. Treasuries have skyrocketed in the few days since the debt ceiling deal was first announced. One explanation is that default is now off the table (not that anyone really believed for a minute that it was on the table), and the threat of a downgrade from the ratings agencies seems to be losing steam. I think a more plausible reason is that the recent flurry of bad news for the economy has the stock market spooked and investors are scrambling for a safe haven.

In the past week, the first quarter GDP was revised down to 0.4% and the Q2 GDP came in at an anemic 1.3%. The employment numbers have been worse than expected and several companies have announced a new wave of layoffs including 30,000 globally from HSBC (HBC), 13,000 from Merck (NYSE:MRK) and another 10,700 from Borders (OTC:BGPIQ). On top of that, Monday’s manufacturing numbers from the Institute for Supply Management were horrible and the market dropped sharply when the PMI number was announced.

This disastrous week of news for the U.S. economy coupled with new (yes, new again) concerns about the debt markets in Italy and Spain sent investors looking for a shelter from the storm in U.S. Treasuries. The bond market is, as they say, the smartest market in the world; so they must know what they’re doing when they send yields on the ten year Treasury down to 2.6% and the thirty year bond down below 4%.

In the eyes of many investors, the U.S. Treasury market is the ultimate safe haven. It is by far the largest and most liquid market on the planet. It has enjoyed 30 years of gains, especially in times of economic trouble. When the stock market crashed in 2008, bonds were the only asset class that performed well. Treasuries are backed by the most powerful nation in the world, and now they are backstopped by the almighty Ben Bernanke. The U.S. Treasury market is truly an island in a turbulent sea of uncertainty.

Unfortunately, after forty years of erosion below the surface, and thirty years of investors piling on, this island is about to sink into the sea under its own weight.

The recent rise in Treasuries is a knee jerk reaction to the stock market turmoil. Those piling out of stocks have limited choices, and the bond market provides the easy solution for a quick safe haven, particularly for large investors who need a liquid market. But beware, it’s a head fake; a trap. The recent spike in bonds is like a piece of cheese in a rat trap enticing you to join the party.

In the greater scheme of things, the raising of the debt ceiling is extremely bearish for U.S. Treasuries. All it means is that our government will continue to spend beyond its means for another year and rack up an additional $2.4 Trillion in debt. The GDP numbers show that our economy has virtually stalled in the first half of the year despite QE2. As we’ve seen in Greece, Portugal, Spain and Italy, interest rates can rise very quickly when government debts grow out of control compared with GDP. America is already approaching a debt to GDP ratio of 100%, and the new debt limit virtually guarantees that the ratio will rise.

And don’t think for a second that our largest creditors have not been paying attention. The debt deal theatrics by our politicians just reinforced to the world how precarious the treasury debt really is, irrespective of a ratings agency downgrade. China has ramped up it’s rhetoric about the fiscal irresponsibility of the U.S. government in recent weeks and top officials in the PBoC have called for reducing China’s Treasury holdings. Japan has been less vocal, but they need to spend their savings on a massive infrastructure rebuild, not pretty pieces of paper from the U.S. PIMCO has shunned U.S. bonds in favor of sovereign debt from Canada and other more stable economies. As we go deeper down the debt rabbit hole, at some point rates will need to rise to attract new buyers, and bond prices will fall.

“Ahhh!” you say. “Ben Bernanke won’t let rates rise because he know’s it will crash the housing market, bankrupt banks, and send the interest payments on the national debt through the roof.” Fair enough. I agree that Bernanke will launch QE3 in some form or another very soon (if he hasn’t already). But if he were to buy up Treasuries to keep rates low, price increases in food, energy, and consumer goods will kick into high gear as the dollar plummets in value. The last round of QE caused the dollar to continue its decline, even against a week Euro, and especially against commodities and precious metals. Each successive round of QE accelerates the rate of the dollar’s decline and soon our foreign creditors will quit throwing good money after bad and begin selling bonds to avoid getting paid back in worthless dollars. Soon, the Fed may be the buyer of only resort!

With Fed induced low interest rates and high inflation, anyone holding bonds will be bled dry by significantly negative real interest rates. Those who try to sell will find few buyers and reduced prices for their bonds. It will be a firesale as individual investors, funds, and sovereign nations scramble to get off the sinking island.

So where will these investors swim for safety? Some will go to sovereign bonds of more financially sound nations and currencies such as Switzerland, Canada, Singapore, Australia and even China as they free up their markets. Some will go to “safe” high dividend yield stocks. But the investors who want true safety and real returns will swim to the one true currency that has stood the test of time and served as a safe haven for thousands of years- Gold!

Gold (and silver) has risen against all currencies for the past decade. In dollar terms, gold has risen over 500% in that time. This fact has caused many run-of-the-mill traders, who have recently begun following gold now that it’s a hot commodity, to declare that gold is in a bubble. What they fail to realize is that paper money has been created at an even faster pace, making gold a better value today than it was ten years ago.

China certainly doesn’t think gold is a bubble as they have been buying the shiny metal at a rapidly increasing rate and will soon eclipse India as the largest buyer. South Korea doesn’t think gold is in a bubble, as they just announced the purchase of 25 tons of the yellow metal in the past two months.

For all the talk of gold these days, relatively few people actually own any. Gold island is still a sparsely populated place. But more and more investors and central banks are flocking there as they realize it is the last, best safe haven remaining. The problem for new investors is that gold island is really small. As people pile on, newcomers will pay exorbitant prices for just a toehold on the tiny island. At that point it will be a bubble, a mania, a full-fledged gold fever. Then, those who reserved their stake on gold island early, will be able to sell their plot, buy a nice yacht, and sail off into the sunset.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.