"Americans love a winner. Americans will not tolerate a loser ... . The very idea of losing is hateful to an American." -- General George S. Patton Why would any rational investor buy a long term U.S. Treasury today? This may seem like a strange question to ask right now. Historically, at least since World War II and considering the dominant position of the dollar and the U.S. economy, Treasuries have usually been the ultimate safe haven investment in troubled times. These are troubled times, possibly the worst since the Great Depression, so why would a rational investor want to avoid Treasuries? Here are a few reasons. In just the last month, the U.S. government has basically taken on nearly $7 trillion dollars of additional liabilities. I arrive at this number by adding the debt of Fannie Mae ( FNM) and Freddie Mac ( FRE), plus the rescue package, and the expansion of Fed's balance sheet. Our gross domestic product (GDP) is about $13 trillion, so that's an enormous amount of debt to add in just one month. Further, the government has now explicitly increased bank deposit insurance, provided an implicit guarantee to trillions of dollars of money market funds and is in the process of now buying hundreds of billions of dollars of corporate commercial paper. All of this means that the supply of Treasuries hitting the market to pay for all of this is going to be enormous. Also, the dramatic increase in future liabilities, without any offset in increased revenue, of the U.S. government reduces the creditworthiness of the U.S. as a borrower. This is already reflected in higher premiums for credit default swaps, which are insurance against a future default, on U.S. Treasuries. Do you really believe this is end of how much money the government is going to spend to fix the financial system and prop up the banks? Nobody knows how big this problem is or how much more the government will need to spend or guarantee to fix it.
If the U.S. is the strongest and most powerful country in the world, why wouldn't investors always want to buy our bonds? Unfortunately, America's dominant position in the world, both politically and economically, is increasingly being questioned. This is not the first time we have been through a rough patch like this in the post-World War II period. A similar period of declining American influence and credibility occurred in the late 1970s following the end of the Vietnam War, Watergate, the OPEC oil shock, rampant domestic inflation, and culminating in the Iran hostage crisis. How did Treasuries perform during that period? The yield on the 10-year Treasury went from under 7% in 1977 to nearly 16% in 1981. During that period, Treasuries performed so badly compared with other investments, including stocks, real estate, commodities, municipals and corporate bonds, that they were sarcastically termed "certificates of confiscation." Obviously, the actions of Paul Volcker, who was Fed Chairman at the time and substantially increased the fed funds rate, contributed to the selloff in Treasuries. However, Volcker was taking those actions in an attempt to restore credibility in the U.S. financial system. His policies were more of a painful remedy, rather than a cause, of the problem. In fact, Treasuries were already performing badly before Volcker even started running the Fed. The underlying problem was a crisis of confidence in the U.S., not Volcker's policies. What about the asset deflation that everyone keeps talking about? Shouldn't that keep inflation down and support Treasuries? There is, unfortunately, not a consistent and direct link between asset deflation and deflation in consumer prices.
Everyone already knows this is true in reverse. We had tremendous asset inflation in the 1990s and falling inflation. Since everyone, except commodity producers, benefited from that disconnect, few people questioned it. While it is true that falling asset prices reduce demand, which does have a deflationary impact, there is a lot more to the inflation story than demand. As Milton Friedman said, inflation is a function of monetary policy and money creation. The more money printed, the more inflation you're going to have. In fact, with the combination of asset deflation and excess money creation, the logical result is even more price inflation than if assets were inflating. The reason is that the money being created needs to go somewhere. If it isn't going into assets, it will go into goods, services and commodities, all of which feed into reported price inflation. If our currency continues its decline, that will also increase inflation, especially for anything that's imported, regardless of what's happening with assets deflating. Even so, isn't inflation today always going to be dramatically lower than in the late 1970s and early 1980s because of global competition keeping wages down? Unfortunately, this view is based on two faulty assumptions. The first is that a big part of the decline in reported inflation during the past 20 years has been the result of more and more creative ways that the government has simply redefined what inflation actually is. Think of this sort of the way President Clinton said "That depends on what the definition of 'is' is."
Seriously, the government has gone to great lengths, using "hedonic" adjustments, changing the basket of goods and services for the inflation calculation, using "owner's equivalent rent" instead of housing prices, and even excluding certain items entirely that have rapidly increasing prices to reduce the reported inflation numbers. The second problem is that global competition is no longer only a deflationary force. Wages have been rising rapidly throughout the developing world. Also, demand for goods and services in the developing world are exploding. This has put upward pressure on energy and other commodity prices. Even based on the government's inaccurately low reported inflation figures, the recent headline numbers have been in the 5% to 6% range. Analysis by several independent economists and market watchers has shown that if inflation were calculated similarly to the calculations used during the early 1980s, our headline inflation numbers would be over 10% right now. That compares with a 10-year Treasury yield of around 3.5% -- before taxes. Buying a security that appears to guarantee a substantial loss is not my idea of a rational investment. With stocks crashing, even the best corporate credits suspect, and cash yields also very low, what can a rational investor who is concerned about safety and some income buy right now? For an investor concerned with safety and income, I would focus on relatively short term AA- and AAA-rated municipal bonds, GNMAs and also the debt of Fannie and Freddie. Municipal bonds are probably the best value right now that they have ever been.
Historically, due to their favorable tax treatment and very low probability of default, municipal yields have been lower than Treasuries. Today, their yields are substantially higher than Treasuries mostly because of turmoil in the insurance markets and on Wall Street, both of which are heavily involved in the issuance, sale, underwriting and guarantees of municipals. GNMAs yield substantially more than Treasuries and are backed the U.S. government. Fannie and Freddie debt is also now more explicitly backed by the U.S. government and yields substantially more than Treasuries. What about diversification? Shouldn't Treasuries be part of any balanced portfolio? PIMCO's Bill Gross, who is considered by many people to be the best bond fund manager of all time, doesn't seem to think so. He has been selling Treasuries to buy more Fannie and Freddie debt. Nevertheless, if you must own some Treasuries, you should probably buy TIPS, or Treasury Inflation Protected Securities. Although these don't really protect you from inflation because the government is reporting inaccurately low numbers, they are probably going to perform better than Treasuries that are not inflation protected. The bottom line here is that U.S. bonds are only as good as the confidence investors have in our country and our government. That confidence has been shaken and will probably take years to restore. I am an optimist about this country, so I believe we will eventually get back on track. However, in the short term, I believe that it is prudent to be very cautious. I agree with Seth Glickenhaus, a 94-year-old money manager who lived though the 1929 crash and the Great Depression, who believes that the U.S. has become soft. We have become more concerned about comfort than productivity. We have worshipped at the altar of immediate gratification and easy credit for decades.
Hard work and savings were too often replaced by borrowing and spending money we didn't have to buy things we didn't even need. These trends need to reverse if we're going to get out of this mess. This is a painful period for everyone. Nobody likes recessions, but we can think of it this way -- the U.S. rose to become the greatest country in the world directly following the Great Depression, one of the worst periods in our history. Sometimes, it is in the darkest days that people, and countries, find their character and rise to become even better. One thing that has not changed in all these years is that this nation still hates a loser and loves a winner. It's that kind of spirit that is going to carry us through this difficult period and toward an even better future.