Understanding the Changing Landscape of U.S. Treasuries

The world can often be unpredictable, and its rapid transformations can catch us by surprise, especially in the financial markets. Many have learned this lesson the hard way, facing unexpected changes that can be both costly and humbling.

For many years, it was widely accepted that “house prices always rise.” This belief spread quickly and became a certainty in the minds of many. However, that certainty was shattered when the seemingly impossible occurred—house prices began to decline.

Similarly, the investment philosophy of simply “buying and holding” an S&P 500 index fund was once considered a guaranteed path to retirement wealth. It was an easy and straightforward strategy that anyone with a 401(k) could adopt. Nevertheless, that ideal was put to the test as the stock market chugged along, often frustrating long-term believers.

These days, it is widely known that “U.S. Treasuries are the safest investment globally.” Recently, however, this notion was challenged when Ten-Year Treasury yields plummeted to an unprecedented 1.91%. Such a drastic decline indicates that investors are willing to lend their hard-earned money to the U.S. government for ten years with little to no return.

At the Economic Prism, we observed this development with a mix of shock and disbelief. Are investors becoming irrational?

We anticipate that the answers to these questions will soon unfold. What’s more, we believe that U.S. Treasuries may no longer hold the reputation of being the safest investment—the implications of which many investors have yet to grasp.

However, this isn’t the only factor we should consider. What other influences could be driving treasury yields to such low levels?

The Market is Responding

Back in 1961, during President John F. Kennedy’s administration, the Federal Reserve implemented a strategy known as “Operation Twist.” This involved selling short-term debt while purchasing long-term securities, thereby narrowing the yield spread between two and ten-year Treasuries.

Recently, the Federal Reserve Bank of San Francisco pointed out that Operation Twist successfully reduced long-term Treasury yields by 0.15 percentage points. While it remains uncertain whether the Fed will resort to such market interventions again, the mere mention of this strategy may already be influencing market dynamics.

Earlier this week, Bloomberg reported that the Federal Reserve might purchase $520 billion in longer-maturity Treasuries while offloading shorter-term debt, potentially driving the 10-year yield down to as low as 1.6 percent.

According to CRT Capital Group LLC, the Fed holds $1.64 trillion in Treasuries, including $520 billion in debt maturing in 2014 or sooner. This could be sold and reinvested in securities set to mature between 2018 and 2039, extending the duration of the central bank’s government debt portfolio from 4.9 to 7.4 years, as outlined by strategists David Ader and Ian Lyngen.

“The market is pricing it in,” Ader explained in a phone interview. “Everything seems on the brink of breaking down. The Fed feels compelled to act or at least wants to convey that it still has some options available to sustain optimism.”

Why U.S. Treasuries May No Longer Be the Safest Investment

There are clear ramifications from artificially suppressing interest rates. For starters, this practice promotes increased borrowing while disincentivizing savings. It tends to benefit spenders, such as the U.S. government, while punishing those who choose to live within their means. Consequently, this results in an economy that drags along at a snail’s pace.

The fervent advocates at the Federal Reserve and Treasury continue to operate under the misconception that if they can stimulate consumer spending, they will pave the way to an economic paradise. They fail to recognize that the once-thriving consumer appetite has shifted.

“Even when considering various financial pressures, households seem unusually cautious,” Fed Chairman Ben Bernanke remarked during a recent speech to the Economic Club of Minnesota.

It is irrelevant to those controlling monetary and fiscal policies that consumers have reached their limits. The Fed and Treasury will persist in undermining government debt until a breaking point is reached—either through economic improvement or a collapse in debt markets. We suspect the latter is more likely, as they won’t cease their actions until they achieve their objectives.

For these reasons, we conclude that U.S. Treasuries can no longer claim the title of the safest investment in the world.

Sincerely,

MN Gordon
for Economic Prism

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