It’s the trend that has Wall Street abuzz. For the first few weeks of the year, investors put more money into stock mutual funds than they took out, a trend that hasn’t happened much since the financial crisis. But focusing on what’s happened since the calendar turned is missing a much bigger issue. Investors, spooked by a seemingly endless parade of potential disasters, poured and, in many cases, are still pouring hundreds of billions of dollars into so called safe-haven bonds like Treasuries, which are backed by the full faith and credit of the U.S. Government. That decision has kept many from reaping the full benefits of the stock market’s rally. More importantly, that desire to feel ‘safe’ soon could wind up doing a lot of harm.
I believe Treasuries are far riskier than people likely imagine. Indeed, Treasuries have become fairly speculative at this point. The stated yields on most U.S. Government bonds are below the rate of inflation. Real yields, the effective value of a bond’s interest payment after taking inflation into account, are less than zero! To believe Treasuries will hold their value is to believe that inflation will fall or go negative, something the Federal Reserve’s money printing makes only a remote possibility. The deflation scenario is what we call a “tail risk,” something at the far end of a normal bell curve of outcomes.
Risks Are Real – and Growing
As the commercials say “but wait, there’s more!” It is true the government is unlikely to default, but the risk of bonds losing principal is very real, and growing. Back in 1994, a $1,000 investment in a 10-year Treasury lost around $7 of principal for every 1 percentage point rise in yields. Today, thanks to current market conditions, that investment would lose over $10 for every percentage point rise. I didn’t choose 1994 at random. That was the last year we had a major prolonged selloff in Treasuries. Investors lost principal then but at least they had a 6% coupon to cushion the pain somewhat. Today that cushion is less than 2%, scant consolation, in my view.
I’ll finish this dismal picture with the obvious observation that there is more room for rates to rise than to fall. The Fed Funds rate is effectively at zero now. Where can it go? As a consequence, Treasuries fall short of providing their usual diversification benefits. On the other hand, even if today’s negative real rates were to simply revert to a more normalized environment (not unreasonable given the growth rate of the U.S. economy), yields could rise by as much as three percentage points. The timing for the ultimate day of reckoning is unknown but even a little bit of bond selling would create plenty of supply. With just a little panic, Treasury investors could all be left trying to get out of the door at the exact same time.
Treasuries and Gold – Two of a Kind
So why own Treasuries at all? To answer that I would look at the go-to asset on the other tail of the outcome curve, gold. Most of us can agree that gold is a speculative, volatile asset. Yet we appreciate its historical useful property as a store of value in times when paper money loses its value. Gold pays no interest, racks up storage charges, and is tough to move around. As such, we hold it in scant amounts for the unlikely scenario of very high inflation. A little bit goes a long way.
That is how I view Treasuries today. I recognize that if the economy tanks again, we may very well enter a deflationary period. Treasuries could then potentially provide something of a hedge,
albeit a smaller one than most investors imagine, against a steep stock market fall. But I don’t think this is the central case. I think it is a tail risk. In the meantime the traditional reasons for owning Treasuries, diversification and income, have diminished. If the status quo drags on, both Treasuries and gold could lose a little bit of money after inflation and storage charges, respectively.
However, I believe both assets could wind up being big losers for investors still piling into them. People are so afraid of deflation that they are willing to accept losses in Treasuries if inflation remains steady or rises. People (different ones, presumably) are also so worried about inflation that they have bid up the price of gold 400% since 2005. That’s massively above what inflation actually was since 2005; it would take around 20% annual inflation over the next seven years to catch up.
So people are overpaying for both Treasuries and gold in my opinion. It’s odd because one will win only if the other loses. Both tail outcomes, inflation and deflation, can’t happen simultaneously. It is a measure of the uncertain times we live in that people willingly continue to buy both. I believe the most likely outcome is both factions will be disappointed.
Mutual funds are subject to market risk and volatility. Shares may gain or lose value. Bonds are exposed to credit and interest rate risks (when interest rates rise, bond/fund prices generally fall). Diversification does not guarantee profit or protect against loss.