Barrons: Bursting of Treasury's Bubble

Excerpt.



U.S. Blues
By ANDREW BARY T



The bear market in Treasuries will worsen, because of a glut of government bonds. Instead, consider high-yielding mortgage securities and certain munis.

THE BUBBLE HAS BURST.
We're talking about U.S. Treasury securities, not housing. At the end of 2008, risk-averse investors poured into Treasuries, driving down yields to the lowest levels in decades. The 30-year Treasury bond fetched less than 3%, and short-term T-bills carried yields of zero.

Since then, the economy has shown signs of bottoming, the credit markets are functioning more normally, and the stock market has roared back from its March lows. Treasuries now are in a bear market, while bullish enthusiasm has taken hold in other parts of the credit market, including corporate bonds, municipals and mortgage securities, all of which had fallen from favor late last year. The 30-year Treasury, for instance, has risen to a yield of 4.10% from 2.82% at the end of 2008, cutting its price by 20%.
Barron's called a top in Treasuries and a bottom in the rest of the bond market in an early 2009 cover story ("Get Out Now!" Jan. 5). We weren't alone in recognizing some of the nutty year-end developments. Warren Buffett highlighted the sale in late 2008 by his Berkshire Hathaway of a Treasury bill for a negative yield. Buffett wrote in Berkshire's annual letter in February that when "the financial history of this decade is written...the Treasury-bond bubble of late 2008" may rank up there with the housing bubble of the early to middle part of the decade. - How does the market look now? Treasuries still look unappealing for several reasons. Yields are very low by historical standards, the government is issuing huge amounts of debt to fund record budget deficits, and the massive federal stimulus program ultimately may lead to much higher inflation.
"There are better values elsewhere among high-quality bonds," says Steve Rodosky, an executive vice president at Pimco, which runs the giant Pimco Total Return fund (ticker: PTTAX).........Mohamed El-Erian, was blunt at year's end, saying, "Get out of Treasuries. They're very, very expensive."
While holders of Treasuries ultimately will get their money back, prices could fall sharply in the interim, and repayment could be in greatly depreciated dollars. Treasury yields may rise further in the coming year, meaning that prices will fall as the economy strengthens. The yield on the 30-year bond could top 5% and the 10-year note could rise to more than 4%, from a current 3.15%.........



......Treasury rates aren't apt to shoot up anytime soon, because so-called core inflation, which excludes food and energy costs, is likely to remain around 1% for the time being and because "the economy is turning slowly." Fresh concerns about the economy prompted a 4% sell off in the stock market last week, and a rally in the Treasury market, which tends to move inversely to stocks.
Looking out a few years.....the 10-year Treasury could hit 5.5% as investors seek a real, or inflation-adjusted, return of 3.5%, relative to what may be 2% inflation. It's no secret that the U.S. budget deficit is exploding this year from the combination of weak tax receipts and sharply increased spending. The Obama administration recently increased its deficit projection for the current fiscal year ending in September to $1.84 trillion, from the $1.75 trillion estimate made in February, and lifted its 2010 deficit estimate to $1.26 trillion, from $1.17 trillion. That compares with a $458 billion gap last year.
THE RESULT IS A LARGE INCREASE in the issuance of government bonds......The growth in bond supply is particularly pronounced in seven-year, 10-year and 30-year maturities. One sign of trouble was the poor reception in a recent sale by the government of 30-year bonds.
The government-bond glut is hardly confined to America. Combined issuance in the U.S., Europe, Japan, Canada and Australia could come to $4.2 trillion this year, according to British financial historian and author Niall Ferguson......
The U.S. Federal Reserve is trying to sop up part of the bond deluge with a program to buy $300 billion of government debt through the end of September......The Fed also has a program to buy $1.25 trillion of agency mortgage securities as part of an effort to depress mortgage rates, now averaging around 5%.
The Fed may succeed in artificially depressing Treasury rates for the time being, but the Fed program will end eventually, removing a key piece of support for the market. The Fed could get stuck with sizable losses if rates rise, since its holdings of bonds and mortgage securities, now $1 trillion, could double by the end of 2009....

...OVERSEAS DEMAND, PARTICULARLY from central banks, has supported the Treasury market in recent years, but that buying appears to be waning. China, for instance, sees sharply slowing growth in its foreign-currency reserves this year due to weakening exports, a development that reduces the country's demand for Treasuries. Chinese officials also are worried about the country's $1 trillion-plus holdings in Treasuries and other U.S. debt because of the risk of a weakening dollar and higher inflation......



Comment: As we have told clients, you can find many yield areas of the market today where you are paid to take risk. Treasuries and money market accounts are not currently in this category.



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