Warren Buffett has recently been criticizing the bullish case for safe haven investments such as gold and Treasuries. I have tended to disagree with Warren Buffet about other trades, but he is spot on when it comes to his warning about the dangers of Treasury bonds.
The reason I agree with Buffett's outlook in the long run is pretty clear. With the five year yield under 1%, the ten year yield under 2%, and the thirty year yield just above 3%, U.S. government bonds are at post WWII highs. They are pricing in several years of an economic deflationary depression (which even permabears say is unlikely). Whether the economy continues to recover or falls back into recession, the outlook is still bleak for Treasuries. With a debt to GDP level 100% and annual one trillion dollar deficits that add at least another 10% to that ratio each year, the U.S. government is on the verge of insolvency. If the ten year yield rises just 250 basis points, the U.S. will have an giant version of the Italy crisis emerge stateside.
On the other hand, if the U.S. economy recovers, investors will switch away to Treasury bonds and the U.S. dollar to risk assets as Treasuries generate a negative real return. With Ben Bernanke printing record levels of money through quantitative easing programs and by keeping interest rates at zero percent, real interest rates will remain negative for at least the next three years (probably longer as Fed rate hikes historically lag inflation). Even with record low money velocity and a slow U.S. economy, inflation averaged 3.16% in 2011. Velocity will pick up back to historical levels with the economy which will drive inflation back to 1970's levels. Bond holders would not only lose nominally from higher rates, but also in real terms through the debasement of the U.S. dollar. Due to extent of the U.S. government's current fiscal and monetary policy situation, there are only three possible outcomes for Treasuries: Lowering of the American government's credit worthiness, higher inflation, and/or the Fed increasing interest rates. All three scenarios are terrible for bond prices, and the probability of at least one of these three outcomes happening is near certain. The government will have to pick one of these scenarios to solve its impending debt crisis because investors will not remain complacent with low yields and rising inflation expectations. Due to political expediency, I believe that using the "inflation tax" is the most likely outcome and bond holders will lose more in purchasing power than the nominal loss that would have occurred in an honest default. However, I would not be surprised if the market perceives increased credit risk of Treasuries and rating agencies issue further downgrades.
Does this mean investors should bet the farm on ProShares UltraShort 20+ Year Treasury (TBT), the PowerShares DB 3X Short 25 Year (SBND), or puts on Treasury bond futures? As of now, not yet. The crisis in Europe and the Chinese hard landing have not fully played out. Japan, a country with similar debt problems to the U.S. at a much more dire degree, still has not seen its bonds break down. I believe weakness in Japanese government bonds will prelude declines in U.S. Treasuries. As a result, there are plenty of scared international banks and investors who will flock to T-bonds. However, once these problems are fully priced into debt and equity markets (six to nine months from now is my best guess), I plan on aggressively entering Treasury short positions. Until then, watch the panic generated from crises in Europe and Asia for an opportunity to catch the peak of the bond bubble.
Overall, Buffet is right about avoiding government bonds. With record low yields, there is limited (if any) upside to buying Treasuries. However, with excessive money printing, higher inflation expectations, and historically a bad balance sheet of the U.S. government provide plenty of long term downside.