Financial bubbles can occur anywhere. The notion that they only occur in "risky" (in quotes to emphasize the wide variance in the perception of risk) assets is simply a fallacy.
Let's not forget that in the early 1970s, investors managed to turn safe, blue-chip companies into speculative, super liquid trading vehicles with unjustifiable valuations. Companies like McDonald's (NYSE:MCD), Disney (NYSE:DIS), and Sony (NYSE:SNE), all well known behemoths, traded at price to earnings multiples over 70. Of course, one of the main reasons for the rampant purchasing of what were termed the "Nifty Fifty" was that they had massive market capitalizations, and could therefore be acquired by large institutions without causing a massive spike in the stock price. Amazingly (or not so much), investors failed to recognize the irrationality in implying enough annual growth to satisfy a P/E of 70 for a company already worth hundreds of millions, or even billions of dollars.
With this truism clarified, it is crucial for (typically older) investors to understand that United States treasuries, in all their forms, are tremendously risky. Warren Buffett has often been quoted as saying, "if I could, I'd rate the U.S. credit as AAAA if I could." Surely, the word's most prolific investor is not mistaken. Mr. Buffett obviously understands that the U.S. has basically no real chance at defaulting on its debt, simply because it is one of the few major nations that can print its own money.
"Great!" You may say. There is no credit risk on the borrower's side, so no loss of principal risk. Unfortunately, and quite obviously, it's not that simple.
The Fiat Currency Disaster
For those who are not familiar with the reasons for why governments absolutely love fiat currencies, particularly those that they themselves can print, here's a brief summary.
Central governments have long been the beneficiaries of fiat currencies. They theoretically allow for unlimited spending, and in practice, we are seeing the effects of that today. Endless spending has obvious political benefits. Taxpayer money can be spent on a variety of lavish projects, massive wars, the poor (for votes), and anything else to aid politicians stay in power or line their pockets. Once the taxpayer has run dry, or the debt has been run up to what would have been an unsustainable level, the printing presses fire up.
While some start (correctly) hollering that printing is dangerous, out of the woodwork come the Keynesians, like Paul Krugman, who start babbling about how the money supply can be tripled, and consumers will benefit from the new wealth without any increase in the prices they pay for everyday products. The Keynesians tirelessly refute that the exchange rate doesn't affect consumer prices. This is where readers should begin scratching their heads.
While we not only pay more for goods made directly overseas, the companies that sell us goods back here in America use materials and other products that they themselves purchased abroad. These higher costs of production ultimately get passed on to consumers.
The Fed's Fudged Inflation-Talk and our Inevitable Demise
But where is the inflation we were supposed to be seeing so much of? It's here! The consumer price index is up 3.4% over the last 52 weeks, yet we're being told that we are in the midst of a zero inflation atmosphere. What the heck is going on?
This inflation will get worse. Much worse. If you think about the action in treasuries over the last couple of years, you see exactly where the money has gone. Banks obviously refused to loan money out, and along with nervous consumers, have plowed most of their cash into low-paying treasuries. But what happens if the economy actually begins to improve (it won't, by the way)? Money will flow out of treasuries and into consumer product markets, throwing off massive amounts of new, cheap cash into our economic system. What kind of inflation will we see then?
Keep in mind, our CPI has been modified over the last several decades to better suit the motives of those in charge. The CPI doesn't even include the items that we really purchase frequently, and the items that make the biggest dent in our wallets (like oil and food). Who knows how heavily it has really been modified. Our real CPI is probably closer to 6% (all this in what can only be called a no-growth environment).
House of Cards
Let's project out into the future a little bit. Let's assume the Federal Reserve's money printing (currency debasement) provides enough artificial stimulus to reinflate the bubble to the point where consumer demand causes prices to rise above 5%. At this point, a zero percent interest rate policy could be catastrophic going forward, so the Fed will have to raise rates. This rate increase will cause the cost of servicing our $15 trillion debt to skyrocket. If inflation really gets out of control, we're deadlocked. A further increase in rates would cause debt payments to become impossible without impossibly fast money printing, resulting in a subsequent run on the U.S. dollar and treasuries.
On the other hand, let's assume we continue on this no-growth path, while continuing our money printing to service the debt, keep spending at current levels, and (so we're told) help out consumers. Once again, we end up in the same spot, only a little prolonged, perhaps. Currency debasement eventually causes prices to rise to a dangerous level, and the same events play out.
For those who question if the money supply has really been growing that much (from www.shadowstats.com):
Please note that a downward slope (after around 2006) merely illustrates a decrease in the rate of growth, not a shrinkage in the money supply.
The (What Should be Obvious) International Treasury Bubble
Sure, I'll get hit with plenty of comments that mention my thinking isn't exactly revolutionary, and that everyone knows it's a bubble, so it's not really a bubble. However, I think the market speaks for itself when people are loaning a spending-addicted, politically childish borrower 10 years worth of principal at 1.85%, or even more outrageously, 30 years at 2.80%. Treasury investors simply don't understand how structurally flawed our economy really is.
The U.S. may not technically default, since they can just print the money to pay you back, but what is your principal going to be worth in real terms in 10, 20, or 30 years? Are annual payments that are less than inflation going to ease your financial pain? Obviously not, and domestic investors will probably sooner or later realize that in the "printing scenario" that is all too-often considered OK, their purchasing power of the dollars they are being paid back with will be so depreciated that they're effectively poorer.
Even if they don't, foreign creditors are reaching a tipping point, and are pretty damn close to stopping their swallowing of our endless debts. Foreign purchases have been a huge segment of demand over the last couple of decades, and countries like China will have very little patience if we don't legitimately start making an effort to liquidate the debt. Foreign investors will begin what will be an inevitable run on U.S. treasuries.
These issues are not constrained to the United States. Investors in German Bunds could be at a real risk, and Germany (thankfully, for the long-term health of the global economy) cannot print their own money. Investors in Japanese bonds are lending one of the world's most leveraged and simultaneously declining economies 10 years loans at 1%. Great Britain's consolidated debt to GDP ratio is nearly 1000%.
The issue is, as Gordon Gekko said, systemic, global, and exactly like cancer. It will reset the global economy as we know it, and investors in U.S. treasuries have some of the most to lose.
I'm not bearish by nature, I simply find it appalling to ignore what our future inevitably holds, just to continue clinging to the idea that our current standard of living will continue indefinitely.
With the exception of a plan to rapidly liquidate our debt in a thoughtful manner, there is simply no way this thing ends nicely. Treasury investors are seeking safe-havens, but there is nothing safe about long-term treasuries. The risk-benefit profile of an investment in a long-term treasury is stunningly weighted towards it being a risky asset, but the yield simply does not reflect the risk.
Remember, too, that aside from the risk of loss of principal, or loss of purchasing power, the value of your bonds, should you decide to sell, will be worth significantly less in the next couple of years no matter what.
What we do know is that the government will continue to sell mass amounts of treasuries on the open market. Treasury prices, like any asset, eventually abide by the laws of supply and demand. The supply of treasuries is going to become even more overwhelming over the next few years, and demand is certainly going to diminish from the biggest players.
There is simply no way to win with treasuries, and endless ways to lose. The only way to protect your wealth is to own physical gold or other precious metals (something which I was completely opposed to until fairly recently), productive land in fresh, financially healthy economies (not readily available for most of us), and stocks of companies with incredibly strong business models and growing cash flows, such as Coca-Cola (NYSE:KO), Dollar General (NYSE:DG), and Sanofi (NYSE:SNY).
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in SNY over the next 72 hours. I own physical bullion.I may enter long positions into TBT and other shorting/put option methods on treasuries at any time.