“Complacency in Treasury Land?”

Sydney M. Williams

Thought of the Day

“Complacency in Treasury Land?”

July 10, 2012

Thirty-one years ago, the yield on the U.S. Ten-Year was 15%; today it is 1.5%. According to a Merrill Lunch study, those three decades provided Treasury bond holders compounded annual returns of 11% – a record, like Secretariat’s 2:24 for the mile and half Belmont Stakes in 1973, one that might stand for decades. A question for investors becomes, have so many years of superior performance caused too much complacency? Keep in mind that means $1,000,000 invested would provide annual pretax income of $15,000 for ten years. With current inflation running over two percent, the real annual return would be negative even before taxes. Does Hans Christian Anderson’s story apply? Is the Emperor naked?

Three decades ago, inflation was the major concern for investors. According to the U.S. Department of Labor, the annual inflation rate averaged 7.2% for the fifteen years ending in 1982, versus 2.3% in the prior twenty years. Markets, as is their wont, overcompensated, sending the yield on the Ten-Year from 2.25% in 1950 to 15% in 1981. The attack on inflation by then Fed Chairman, Paul Volcker and President Reagan provided the impetus for the biggest bond market rally in the history of our country. The annual rate of inflation over the past thirty years has averaged 2.9 percent – a rate now above the yield on the Thirty-Year Treasury. Are we seeing the opposite side of the same coin?

A natural, consequence of cheap money (low interest rates) is the accumulation of debt. We saw that among consumers over the past several years, culminating in the housing crisis, which began to unfold at the end of 2005. (The LIBOR scandal was a manifestation of banks favoring their proprietary derivative traders at the expense of the borrowing needs of their commercial and consumer customers.) Non-financial corporations, generally more cognizant of the negative consequences of debt, generally shored up their balance sheets several years ago, but because of uncertainty in financial and political arenas have been hesitant to invest. While consumers, in very recent years, have paid down some debt, governments have more than made up the difference, spending like drunken sailors to stimulate, without much effect, their lagging economies. However, the largest proportion of our spending has gone to maintain safety nets imperiled by a lackluster economic recovery. For example, 5.4 million people have been added to Social Security Disability rolls in the past three and a half years, roughly double the total number of jobs that have been created over the same time.

Thus far, the most damaging effects of debt have been muted by unusually low interest rates, and the U.S., in particular, has benefitted as being considered safer than most all other alternatives around the world. For example, according to “Grant’s Interest Rate Observer,” Foreign central banks holdings of U.S. government securities held at the Federal Reserve, as of last week, totaled $3.5 trillion, 22.7% of today’s GDP. That would compare to 2.8% of GDP in 1976. Money continues to flow into our debt markets regardless of inherent, long-term risks. It has permitted, I suspect, a level of complacency to creep into markets. Being the prettiest girl on the block, when there are no other girls, is not necessarily a compliment.

Total US Federal debt of $15.7 trillion exceeds last year’s GDP of $15.1 trillion – the first time that has occurred since World War II. That places the U.S. in a class with Barbados, Ireland, Portugal and Sudan – better than Italy and Greece, but worse than Spain. However, as the world’s reserve currency we can afford to be less prudent than others.

Nevertheless, a one percent increase in interest rates would add $157 billion to last year’s total interest expense of $222 billion. Were interest rates to revert to the levels of the early 1980s, debt service would exceed last year’s entire budget! As Bill Gross notes in his current “Investment Outlook”, a debt crisis, such as we are experiencing, can be cured with more debt “if initial debt levels are reasonable and central banks are able to rejuvenate the delicate balance between debtor and creditor – each believing they are getting a good deal in terms of risk, reward and the deployment of funds between now and some future maturity.” But, with total Federal debt at more than 100% of GDP, it would be a stretch to call our debt levels “reasonable.”

It may be that the balance between risk and reward will be normalized on a gradual basis; creditors will demand more in terms of return, and rates will slowly rise – a consummation devoutly to be wished. But markets are rarely so kind. Mr. Gross points out that there are only two ways by which an authentic government debt crisis can be cured – default, or inflate through the printing of more money. A fiat currency, such as the U.S. Dollar, the Euro and most major currencies today, is dependent on faith. When investors lose confidence in the currency it weakens and rates rise, potentially precipitously. It does not appear to me that buyers of U.S. Treasuries are considering the potential negative consequences.

Alex Pollack of the American Enterprise Institute published an article three months ago in The American, entitled, “Fearful Symmetry: Six Decades of Treasury Yields.” In it he presents a chart depicting the yield on the Ten-Year over sixty years. It looks like the Matterhorn. Yields rose for the first thirty years and declined for the second. For twenty-one years, 1972 – 1993, the yield on the Ten-Year was never less than 6%. For the last twelve years, it has never been higher.

The past is never a perfect predictor of the future. Nothing is that easy. Mr. Pollack’s chart goes back to 1950, but if one extended it back to 1940, the rate on the Ten-Year was 2.21%, virtually the same as it was ten years later. In fact, if one went back further, to 1930, the yield on the Ten-Year was 3.3%, suggesting that rates can go sideways for long periods of time. However, one has to factor in that those two decades – 1930-1950 – encompassed ten years of Depression and five years of a World War. Predicting the future is a fool’s game. Perhaps rates will stay at very low levels for several more years? No one knows. But there are big differences. Ten years into the Depression, in 1940, Federal debt as a percent of GDP was about 50%. Ten years later, after the War, Federal government spending was 15% of GDP. Today, three years after we have (supposedly) recovered from recession, debt is over 100% of GDP and Federal government spending is 24% of GDP. We have painted ourselves into a corner, limiting our options.

In a world that has become increasingly risk averse, whether we are speaking of geopolitics or investing, the Treasury market stands as a perceived bastion of safety. Is it not possible, though, that the beneficiary of the “risk off” trade is perhaps very risky indeed?