The Great Treasury Trap...
Originally published December 6th, 2008.
One of the more unusual manifestations of the financial meltdown this year has been the dollar spike, that caught a lot of traders by surprise, and was generated in part by a stampede into the percieved safety of short-expiry US Treasuries, which necessitated the purchase of US dollars. This is now arriving at its ultimate conclusion where Treasury yields have been beaten down to zero, which means that in real terms they are negative, resulting in the bizarre situation where investors are now paying the US government for the privilege of lending them money. This is clearly an untenable circumstance that cannot be expected to continue indefinitely, and it has only been occasioned by desperation, as panicked investors have sought safe haven.
Just how extreme this situation now is is readily apparent on the long-term chart for the 3-month Treasury Bill Yield. As we can see the yield has dropped very close to zero, meaning that investors are getting a negative real rate of return. What this means is that investors are completely out of ideas, and are prepared to settle for losing less in Treasuries than they fear losing elsewhere, such as in commodities or the stockmarket. This also suggests that bearish sentiment is at critical lows, which is in itself bullish.
Having driven yields down to zero in short-expiry Treasuries, and thus exhausted their potential for upside price appreciation, the next logical step for the panicked has been to fan out into the more risky long-term expiries, which is why we have seen the 30-year T-Bond price race ahead over the past few weeks and break out and advance vertically to new highs.
The vertical advance in the long bond price is of course having the effect of collapsing its yield, as we can see on the long-term 30-year T-Bond yield chart below. Since the yield could theoretically continue to collapse towards zero, we could yet see further appreciation in the price of this bond, although being already critically overbought, it may pause to unwind the overbought condition first.
Watching investors fleeing into the perceived safety of US Treasuries is akin to watching people board the Titanic in the movie - you know that they are doomed. This is because the United States is totally bankrupt - more than bankrupt in fact, since its debts are physically impossible to repay in any circumstances and what we are witnessing now is the cowards way out - the creation of money in whatever quantity is necessary to prevent total gridlock. The Paulson bailout plan was a Trojan Horse that opened the floodgates to exponentially expanding bailouts that have already ballooned to something like 10 times the original $700 billion. This has one inevitable outcome - hyperinflation, which, incidentally, can take hold even in conditions of deepening recession/depression - and it looks like the US now faces the particularly grim prospect of depression coupled with hyperinflation. Like most assets, Treasuries will be ravaged by hyperinflation and rendered worthless as the dollar is destroyed, with the added ever-increasing risk of default thrown in. Thus, it is clear that those cowering in their perceived Treasury safe haven are in for a very rude shock. They should have bought gold, which has no counterparty risk and whose intrinsic value can never be destroyed, but they have been miseducated to believe that gold is a commodity when it is in fact pure money. By the time they wake up to this fact they will find themselves scrambling to cash in Treasuries whose value will be rapidly evaporating to switch into gold which will be running away from them faster than they can catch it.