Posts Tagged ‘Treasury bonds’

Why are nothing-yielding US Treasuries so popular?

Sunday, February 22nd, 2009

One of the thing that confounds us is the fact that short-term US government bonds are yielding almost nothing. A 10-year US Treasury bonds yields a measly 2.79% while a 30-year bond yields 3.57%.

There are two common explanations for such a curious phenomena:

  1. It’s a flight to ‘safety’
  2. The market is pricing in price deflation in the US

With the US printing money and its government fallen in trillions of dollars worth of debt (see How is the US going to repay its national debt?), why are investors still pouring money into government bonds that are pretty close to junk?

Isn’t it obvious that the ridiculously low long-term US Treasury bonds is in a bubble? Marc Faber once said, “It’s time to short US government bonds, BIG TIME!”

Well, we have found a very good explanation for that. Remember in Bernanke ticking off another inflation trick- buying Treasury securities, we said that Ben Bernanke was suggesting that the Fed buys up US Treasury bonds? Basically, the Fed is creating money out of thin air to prop up the prices of these bonds. Therefore, what is there to fear if bond yields are ridiculously priced?

With that in mind, even mainstream investment analysts are recommending such junk government bonds. In Treasuries still strong: Merill Lynch, it reported that

Stephen Corry, Merrill Lynch, chief investment strategist for global wealth management, believes that the US Federal Reserve cannot allow Treasury yields to climb much higher than its current levels of around 2.6 per cent.

Consequently, we are seeing the weird situation whereby both gold and US Treasuries are going strong. Our bet is that gold will win eventually.

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Posted in Market Observations | 2 Comments »

Hedging against deflation

Monday, October 6th, 2008

The recent nationalisations, collapses and runs on banks in the US and Europe brings a new dimension of economic uncertainty to many people. The last time such things occur in the developed Western world was during the Great Depression in the 1930s. For this current generation of economists, financial analysts and money managers, a credit crisis is something that is supposed to occur only in textbook studies of the past. But recent financial market events brought such abstract history into real life. Suddenly, the idea that cash is no longer safe is a rude surprise for many. If cash is no longer safe, then where else can you hide?

This is what is technically called “deflation.” Deflation is not as simple as just falling prices. It is, as we explained in Will deflation win?,

A falling money supply is the definition of deflation, for which the symptoms will be falling asset prices, which if prolonged enough, will lead to falling consumer prices. But before we go off to celebrate falling prices, remember that this is an evil type of deflation because it is the type that is associated with bad debts, bankruptcies, unemployment, falling income, bank runs and so on.

We recommend that you read our guide, What is inflation and deflation? for more information about this topic.

So, if you are particularly concerned about deflation, how should you protect yourself? As we said before in Should you hold gold or cash in times of deflation?,

You see, the ?cash? that you had deposited in a bank is an asset to you but a liability to the bank. In times of severe economic conditions (e.g. during the Great Depression), can your bank honour its liabilities? If it can?t, then your ?cash? is in grave danger.

The key thing to remember is that as long as your asset is a liability of someone else (e.g. bank), you have a counter-party risk. If your counter-party defaults, your asset is gone. In this evil kind of deflation, counter-party default is the greatest risk to your wealth. Therefore, there is only two ways to protect yourself:

  1. Choose your counter-party wisely.
  2. Keep your wealth in a physical form such that it is nobody else’s liability.

We will first explain point (1). Basically, the only supposedly risk-free counter-party is the government because it has the executive power to tax and print money (note that we used the word “supposedly”- the Russian government defaulted on its bonds in 1998). If you store your wealth in the form of government debt (e.g. Treasury bonds), you will be guaranteed a periodic payment from the government. As we explained before in Measuring the value of an investment,

For example, if you pay $100 for a newly issued 10-year government bond that pays 6% per annum, you are sacrificing $100 of today?s consumption in order to receive $6 per year for the next 10 years. That 6% is your rate of return on your investment. Now, let?s say you decide to sell your government bond to Tom at $90. The rate of return for Tom is 6/90 = 6.67%. Let?s say Tom sells the bond to Dick at $110, the rate of return for him will be 6/110 = 5.45%. Thus, the rate of return of the bond is inverse to the price paid for it.

In times of deflation, government bonds will be so highly sought after that its free market value will rise. Consequently, its yield (rate of return) will fall. On the flip side, government bonds are completely useless during inflation. In times of hyper-inflation, government bonds are as good as toilet paper.

Now, point (2) is already explained in Should you hold gold or cash in times of deflation?. But we would like to add a few more points:

  1. Gold was an excellent hedge during the days of the Great Depression because the US was still under a gold standard. The government would print a specific amount of US dollars to buy the gold that you presented to them. As we quoted Wilhelm R?pk in Which industry?s profitability grew as the Great Depression progressed?, the gold mining industry prospered during the Great Depression because

    So long as there exists at least one country [the US] on a full gold standard, an essential condition of which is freedom to buy gold from or sell gold to the central institution at a fixed price, there is literally an unlimited demand for the commodity at that price. In other words, not only is a minimum price for the product of the industry guaranteed, but there is, besides, no limit to the amount the market will take.

  2. The case for physical gold as a deflation hedge is weakened if the government insures bank deposits. In the US, the FDIC insures up to $100,000 of bank deposits. In Australia, there is NO government deposit insurance.
  3. But if for whatever reason, you (1) distrust the government’s deposit insurance, (2) have more than the amount that is insured by the government, (3) believes that the government will print lots of physical cash to provide for cash withdrawals in a bank run, (4) put a freeze on cash withdrawals to prevent bank runs, (5) government does not insure bank deposits (e.g. Australia), (6) can only trust storing your wealth in tangible form (6) etc, there is still arguably a case for holding gold as a hedge against deflation.
  4. The US government outlawed gold ownership during the Great Depression. It may happen again this time.

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Posted in Bonds, Gold, Investor Education | 14 Comments »

Awash with cash?what to do with it?

Tuesday, December 19th, 2006

Not long ago, an Australian executive went to the Middle East to promote one of his company?s software systems to potential Arab clients. In his sales pitch, he sprinkled the words ?low-cost? all over to stress the cost effectiveness of the product. After a while, one of the Arabs pulled him aside and growled, ?What do you mean by ?low-cost?? We don’t care about the cost! Just cut the nonsense and give us what we want now!? Upon returning to Australia, that executive remarked that the Middle East is ?just awash with money.?

Just where do all these money come from?

The answer, as you would have guessed by now, is the United States. The US, being in the enviable position of having its money as the world’s primary reserve currency, is not subjected (for now) to the same rules as the other countries?it can spend more than it earns simply by printing its own dollars to pay foreigners. Thus, it can sustain greater trade deficits than would otherwise be tolerated by foreigners.

For years, the US has been running a ballooning trade deficit?its imports, which is paid by its own printed dollars, has been exceeding its exports by an ever-widening margin. From China, the US has been importing consumer goods and from the oil-producing nations, oil. The US dollars that are used to buy oil are nicknamed ?petrodollars? (the money in the above-mentioned story is such dollars).

Today, those foreign countries that account for the vast majority of US imports (namely the oil-producing Middle Eastern nations, Russia, China and Japan) are sitting on so much US dollars that they do not know what to do with it. Therefore, they recycled much of those dollars by purchasing US Treasury bonds. As a result, the long-term interest rates in the US are being artificially suppressed by those purchases.

As we said before in Will the US dollar collapse?, some of these countries are murmuring about diversifying their reserves away from the US dollars because they see that such state of affair is increasingly unsustainable. With the US continually inflating its money supply (printing money), their reserves of US dollars are increasingly become more and more worthless. In fact, we believe that given the swelling amount of US dollars in the world, its current price is overvalued.

Now, here comes a problem. Countries like China and Saudi Arabia are sitting on a massive pile of US dollars parked in US Treasuries. They also know that the US dollars are overvalued and are becoming more and more worthless as each day passes. On one hand, they would not want the US dollar to collapse to its intrinsic value because that would mean the purchasing power of their US dollar reserves would be crunched. On the other hand, they would not want to continue maintaining their holdings of US dollars because they lack confidence in its value. Selling their US Treasuries at once and using the proceeds to buy alternatives to the US dollars will be unacceptable because by virtue of the magnitude of their US dollar holdings, such action will have an immediate and significant impact on the market prices. This will have a very disruptive and destabilising effect on the global financial markets. Thus, the only sensible solution is to quietly and slowly diversify away from their holdings of US dollars so as not to disturb the market prices unduly. This would take a long period of time.

The next question is, what would these countries buy to replace their US dollars?

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Posted in Economics/Finance | No Comments »