Why U.S. Treasuries Are Not in a Bubble

Includes: IEF, TBT, TIP, TLT
by: Firat Ünlü

As has been evident throughout the financial crisis, the framework provided by mainstream economics is out-dated and rests on many false assumptions. Hence, in order to understand how today’s economies work, we first need to establish a solid foundation.

Along the way to modern monetary policy we have witnessed the introduction of central banks. Initially created to act as lender-of-last-resort, their policies have increasingly shaped the business cycle. Economists regard asset markets much in the same way as markets for goods and apply the same principles to them.

It wasn’t much of a stretch hence to come up with the concept of the efficient market-hypothesis (EMH) which has driven much of research on financial markets and monetary policy. Under EMH, the assumption is that asset prices are always and everywhere at the correct price. Following this logic asset-price bubbles can’t possibly exist; there is substantial research whether the Nasdaq was in bubble territory at the turn of the millennium or not.

The fundamental belief in rational behaviour by market participants and markets being in equilibrium leads the American central bank (the Fed) to not taking action even when credit growth in the economy seems excessive to outside observers. There is no reason to step on the brakes as the central bank is in no position to question the judgement of the market.

On the flip-side however the central bank believes that there can be too low a level of credit creation, this lopsided approach in its monetary policy means that it is fighting credit contraction and deleveraging by opening the monetary spigot. A prominent recent example when it was clear to see was after the bursting of the dot-com bubble. The Fed waited until asset prices contracted and jump-started the economy by providing money at very cheap rates.

This arguably fuelled the housing-bubble. The so-called “Greenspan-put” became famous among investors long ago and caused them to take excessive risk as they correctly understood this bail-out mechanism. Paradoxically the belief in free-markets unfettered by government meddling was discarded when markets moved down in favour of intervention.

The key take-away from this is that monetary policy is asymmetrically aggressive, favouring an expansion of credit in the belief that prices at their height reflect the optimal equilibrium. It is thus no surprise that debt went to previously unforeseen levels in this environment.

In Western economies private banks are charged with providing credit. The central bank tries to control the level of demand for credit by increasing or decreasing the rate of interest at which private banks can borrow from it. But before we can move on we need to define inflation. Unfortunately the original definition of inflation has been tampered with and changed from its original meaning. Ludwig von Mises describes the contemporary definition of inflation, that of a rise in prices and wages as a semantic trick. This is just the consequence of actual inflation which itself is an increase in the amount of money and money substitutes.

Even though credit creation is inflationary this effect is usually offset by debtors paying off debt unless a secular trend to rising debt levels exists. Such a secular trend existed; central banks, consumer psychology as well as their behaviour are behind it. We can conclude that inflation is positive for:

credit creation > deleveraging (a)

At the same time inflation is negative for:

deleveraging > credit creation (b)

Aggregate demand is the sum of GDP plus the change in debt. Thus whenever (a) is the case the economy benefits from a temporary boost in demand and whenever (b) is the case the economy falls into deflation. The recommendation of Keynes to use fiscal and monetary stimulus to exit a depression has been misused by policy-makers to make sure that economies don’t even glide into recessions.

But by avoiding recessions, the structural debt-overhang can’t be worked off and dealing with bad loans is merely postponed. Also the private sector becomes willing to take on even more debt more and confident in its abilities to ride out downturns.

Since prices are set at the margin and e.g. the complete housing stock is never traded at once the paper wealth of many households can be increased by just a few transactions. It becomes fiendishly difficult to judge the real value of asset because in a credit-driven environment asset-price inflation in conjecture with rising profits and increased income itself becomes the reason for higher asset prices.

George Cooper in his book “The Origin of Financial Crises” neatly sums the process up:

While credit is expanding the economy will tend to grow, but once credit ceases to expand economic growth will stall, and should credit began to contract economic activity will also contract. If the central bank perceives its role as being to maximize economic expansion it must also seek to maximize credit expansion. When working under the premise of the Efficient Market Hypothesis… such a policy of promoting limitless credit expansion appears reasonable… while the credit is expanding, there will always be a ready supply of variables…suggesting that the expansion is justified.

Now bond yields are too a large degree shaped by three factors:

  • Risk of inflation
  • Capital inflows
  • Default risk

It appears as if the secular trend to rising debt levels in the private sector has been broken and thus a period of deflation will set in. The Fed, on the hand, claims to fight deflation and injects money into the system. This money makes it way for the most part into Treasuries. Default-risk is determined by the ability of the borrower to pay and the apparent willingness of other creditors to further extend credit lines.

As was evident in Japan, irresponsible budget deficits can be financed by a captive financial system. With banks making record profits and edging their way back to adequate capital ratios under the current system there is no incentive for them to change their stance.

Those pointing out that current budget-deficits are unsustainable are right with the outlook and trajectory, but wrong in their assessment of capital inflows which outweigh considerations of default-risk. Thus US Treasuries are not in a bubble, even though the economic foundation is far from solid.

Disclosure: No positions.