Why U.S. Treasury Bonds Aren't the 'safe haven' Investors Think...

By: Money_Morning

In the last few weeks, international investors spooked by the budget crisis in Greece and the turmoil in southern Europe have been flocking into the U.S. Treasury bond market as a "safe haven."

The huge resulting funds flows have pushed the 10-year Treasury bond yield down to 3.16%, very little above its level during the crisis of October 2008. To a rational investor, this is extremely peculiar: After all, what on earth is safe about the "haven" of long-term U.S. Treasury bonds?

Central Bankers "Buy Treasuries"
Whether or not you're the People's Bank of China, long-term U.S. Treasury bonds have been an excellent investment over the past 29 years, since interest rates peaked in 1981. Inflation rates have trended steadily downward, as have interest rates. If you had invested in long-term Treasuries in December 1980, you would have made a compounded 9.71% on your money by December 2008.

That's not much less than the 10.34% you would have made by investing in stocks over that same period, in spite of the huge stock market boom that began in 1982. It is not surprising that the "default setting" for large central-bank investors - such as those in Japan and China - is "Buy Treasuries."

That tendency is still strong, as can be seen by the latest Treasury International Capital flows report, for March. Net foreign investment into the United States totaled $157.7 billion, a record figure. Of that total, $108 billion reflected net investment in Treasuries, including $80 billion from private-sector sources and $28 billion from such official sources as central banks. Clearly, investor fears of a euro collapse were part of the catalyst behind this flood of capital being directed into U.S. Treasury debt.

The Global Debt Bomb
However, when you look closely, it's not clear why those central bankers should have regarded U.S Treasuries as being any safer than Eurobonds of the more-financially solid European Union (EU) countries. Greece is a mess of course, but even Portugal, generally regarded as the next most endangered of Europe's "PIIGS" (Portugal, Ireland, Italy, Greece and Spain), has debt only moderately higher than the United States and a budget deficit that is much smaller. Italy's budget deficit is quite small, while Spain's debt and budget deficit are both below the U.S. level. Only Britain has a budget deficit that is larger as a component of gross domestic product (GDP) than that of its U.S. counterpart.

Japan, meanwhile, has public debt that is much higher than the United States - but that debt is almost all held by domestic Japanese investors.

The really disturbing contrast between the United States and its main global competitors comes when you examine what the various countries are doing to alleviate their deficits. Britain just elected a new government, forming a coalition whose No. 1 job was to reduce the budget deficit.

Within two weeks of taking office, that coalition has made a down payment on the problem, cutting $9 billion in spending. Portugal and Spain have both instituted harsh austerity budgets that promise to bring their deficits down to acceptable levels by 2013.

Admittedly, there might be backsliding in all three countries, but at present it seems as though they have got their budget problems under control - and Portugal and Spain were able to do so without being forced to leave the euro. Indeed, in those two cases the weakness of the euro should be helping their economies considerably. Both countries have major trade relations with the United States and with Latin American countries whose currencies are loosely tied to the dollar; thus a weak euro should boost their exports.

A Lack of Resolve
In the United States, on the other hand, there is still no serious effort to tackle the deficit. Healthcare reform - signed into law in March - added about $1 trillion to it over the next 10 years, or about $200 billion annually from 2015-2019. Not only has the $800 billion "stimulus" bill not been cut back as the deficit problem has become more apparent, Washington is currently attempting to pass another $200 billion of pork-filled rubbish spending. A Deficit Commission will report in December, but by then an entire year will have been lost during which progress against the deficit could have been made.

Nor is the long-term picture any brighter. While the U.S. Social Security actuarial deficit may be manageable, its Medicare almost certainly is not. The Social Security system's cash flow, which was supposed to remain positive until 2017, has turned unexpectedly negative this year because of the recession.

Then there's inflation. The Bureau of Labor Statistics manages the inflation figures actively; the numbers are currently benefiting from a downtrend in "owners' equivalent rent" which accounts very imperfectly for housing costs and is worth one third of the index. The inexorable gold-price rise is indicating inflation ahead, and rising commodities prices over the past year also indicate that the current inflation quiescence may not last much longer.

Only the strong dollar will counteract this trend, but the growing U.S. balance-of-payments deficit means that strength will be short-lived. Naturally, if inflation reappears prominently, interest rates will rise, and long-term U.S. Treasury bond prices will fall.

Thus, long-term U.S. Treasury bonds, far from being a safe haven, are today one of the world's most dangerous investments - imbued, as they are, with both credit- and interest-rate risks. Indeed, given their performance, Treasuries are almost certainly in a "bubble" of their own. Not only should investors avoid them, they should also overweight their portfolios in assets such as gold, which can expect to benefit from Treasuries' inevitable decline in value.

If there's a lesson to be learned here, it's this: Central bankers and international hedge funds aren't always the smartest investors...

Source : http://moneymorning.com/2010/05/26/u.s.-treasury-bonds/

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