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In the last few weeks, Treasury yields have been headed upward - from 2.63% a month ago to 3.33% today on 30-year bonds - and everyone's been asking whether the bubble has finally blown out.
The "Treasury Bubble" became the new boogeyman for many experts and media pundits last year. Its "impending" collapse could potentially crush the U.S. government and throw the dollar into rampant hyperinflation.
But is it a bubble at all? And if so - or not - what's your most prudent course of action?
That's what we'll be talking about today, on the heels of Ben Bernanke's latest announcement that he'd consider purchasing long-dated bonds in the open market to manipulate yields. Will Bernanke's plan be the final nail in the coffin for the U.S. economy and the dollar, or will it further propel a 27-year bull market in Treasuries?
Just the Facts...
That we've been in an almost thirty-year bull market for Treasuries is perfectly clear.
Since October of 1981, when yields hit 15.21% on long-term bonds, Treasury yields have been on a downward trend. And aside from a few reversals in that span of time, yields have consistently been lower each year.
But Bill Gross - Manager of PIMCO's Total Return Fund - admits that the Treasury market is showing "some bubble characteristics," and reiterates a previous statement, "...I have said for the past three months, the governments are very overvalued." Do Gross' cautious statements back up the allegations of Peter Schiff and other "Treasury Bubble" proponents?
The very essence of a bubble is that it's unsustainable in the long run. So let's ask the question; what happens if this bull market continues and 30-year government paper reaches a yield of zero?
Sustained rates at that level would indicate the market's belief that we're in a deep depression. Essentially, the market would be saying that it would rather park money with the government for 30 years - with a guaranteed return of zero - than risk it in private-sector investments. Retirement fund managers would be forced either to adjust their expected returns or abandon Treasury debt altogether.
But investors in zero-yielding Treasury paper would actually be taking on more risk than they might expect. And that's the risk of a rising interest rates...
Interest Rate Risk
Even if Treasury yields reach zero, it's not likely they'll stay there forever. And when yields once again start to rise, it puts the capital investment of bondholders at risk.
Let's say for example that Treasuries are yielding zero and you purchase a US$1,000 dollar 30-year bond without any discount (so you're paying US$1,000 for the bond). Then, rates eventually rise to 1%. That means that buying the same bond will only cost you about US$740, due to the discount added for that 1% compounding over thirty years.
That means you’ve essentially lost 26% of your original investment capital, as the market price of your bond would change to reflect the new issue yielding 1%, where your bond yields zero. This difference gets greater as yields approach zero, so essentially you’re taking on more and more interest rate risk in exchange for ever-decreasing yield rewards.
The "Treasury Bubble" and YOUR Money...
It's hard to tell whether Treasuries are currently in "bubble" mode.
Unfortunately, most bubbles just aren't diagnosed until after-the-fact. While they're clear in hindsight and defining "unsustainable" levels is easier after the bust, the real defining attribute of a bubble is the rampant sell-off and ensuing havoc that come once the bubble has popped.
So should you join in with the "Bubble-phobia" and steer clear of Treasuries?
It's a good idea to steer clear of Treasuries right now, but not because the Treasury-bubble-boogeyman is hiding under your bed. Simply put; the interest rate risk seems far too great for the meager reward of near zero-yielding Treasury securities. In light of the news, we can safely expect Bernanke to do everything in his power to suppress that long end of the curve. And we can probably expect the market - in turn - to continue to disagree, leaving Treasuries in a relatively volatile position.
Instead, Investment Director Eric Roseman believes there's a case for select issues of Investment-Grade Corporate debt. It's also a great time to look at gold, "With interest rates now at 0%," Eric recently said, "the cost disadvantage to holding gold has vanished because high quality Treasury bond yields have plummeted while T-bills pay nothing. Gold will probably safeguard your capital better than paper money in this environment."