Risks of Treasuries bust in 2009

Any signs of less-than-dire economic outcome would batter govt bonds

THE US government bond market, which towers above other assets as the only bastion of strong returns this year, may crumble in 2009.

As the Panic of 2008 wreaked havoc with stocks, commodities and corporate bonds, fearful investors flocked to the perceived safety of government securities, powering the Treasury long bond to its best performance in a generation.

The Federal Reserve’s signals that it may buy longer US government maturities have added momentum to the epic rally, sending the benchmark 10-year Treasury note’s yield tumbling a huge 150 basis points to near 2% in just one month.

Since bond yields and prices move inversely, these plunges have delivered stellar gains to those holding Treasuries.

Meteoric gains

But with the US government expected to issue between US$1.5 trillion and US$2 trillion of debt into the US$5 trillion Treasury market to fund its unprecedented rescues for the financial system next year, the risk of a sudden drop in prices is growing, analysts warn.

“As an investor in the Treasury market I would be very careful,” said Carl Kaufman, portfolio manager for fixed income with Osterweis Capital Management in San Francisco.

Through Dec 19, the Barclays Capital US Treasury Index was up 14.96% year-to-date, a meteoric return compared with the US Standard & Poor’s 500 stock index, down about 40%, and US investment grade corporate bonds’ loss of about 7.4%.

US Treasuries are heading for their strongest year since 1995, but the market has already priced in a deflationary scenario akin to Japan’s “lost decade” of economic growth, most analysts agree.

The total return of the 30-year bond in the year to date is nearly 45%, putting the long bond on course for its best year since 1982, according to Barclays Capital. Then, former Federal Reserve chairman Paul Volcker started to win his battle against inflation, igniting a huge bond market rally.

Now, the long end of the Treasury market has had its best annual rally in more than a quarter century on investors’ deep fears of the global credit crisis and an unusually protracted and painful recession raising the risks of deflation.

Any signs of a less-than-dire economic outcome would batter Treasuries.

The deflation question

“Either we get deflation or not. If we get meaningful deflation, Treasuries will still be the place to be,” said Jay Mueller, senior portfolio manager with Wells Capital Management in Milwaukee, Wisconsin.

Deflation, an environment of broadly falling prices such as Japan experienced in the 1990s, exacerbates economic weakness because consumers and companies put off purchases. This scenario could push US yields down further, even matching the Japanese 10-year government bond’s 1.22%, Kaufman says.

However, “if we don’t get the deflation, that will make current Treasury yields look unrealistic and you will do a lot better in spread product (corporate bonds),” Mueller says.

During 2009, it will likely become clear whether deflation can be avoided, he says. Mueller puts the chances of the US economy skirting sustained deflation at about 60%.

If that near-miss happens, the economy will probably be very weak but not depressed, pushing up the US 10-year yield to about 2.25% a year from now, Kaufman says. — Reuters

On Tuesday, the 10-year note was yielding 2.17%, not far above its five-decade yield low of 2.04% hit on Dec 18.

No rich pickings

”From here, I don’t think you will get rich on the 10-year,” Kaufman says.

If the US economy were to show some feeble signs of recovery during 2009, then the 10-year note yield could rebound to say 3%, handing its holders a loss of 4.5% in total return, Kaufman adds.

If the United States were like 1990s Japan with enough economic weakness and deflation, then nominal government bond yields could stay very low despite hefty issuance, says Mueller. But Japan’s savings rate is very high, compared with a near-zero savings rate in the United States, which could make demand for US government debt weaker and allow Treasury prices to fall more easily, he warns.

“If you have enough weakness and deflation, Japan at least was able to float enough debt with nominal interest rates staying very low,” Mueller says. But he adds: “Japan’s domestic savings rate was much higher. Could we pull the same trick off?” — Reuters