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    U.S. Treasuries and Inflation

    Guy Conger

    I am of the opinion that 10-year Treasury bond yields touched a long-term low of 1.4% in July 2012. Therefore, that point marked the end of the bull market for Treasuries and the beginning of a long-term bear market. There are several reasons for this critical conclusion, which might help investors in rebalancing their portfolios.
    Investors should note the reasons for bond yields touching record lows in the last few years. On analysis, risk aversion and liquidity freeze comes in as the most important factors. Bond yields slumped during the Lehman collapse and the subsequent credit freeze leading to an economic free-fall. Bond yields also slumped in 2012 on renewed fears of global recession and a deepening crisis in the Euro zone. However, after the announcement of the sterilized unlimited bond purchase program by the ECB and the unlimited bond purchase program by the Fed, the bond yields stabilized and started to trend higher.
    Currently, the global financial system and the US financial system are flooded with liquidity, and banks are in a relatively safer position than they were in 2008 or 2009. My point is proved by the fact that excess reserves of depository institutions with the Federal Reserve currently stand at $1.4 trillion. Therefore, it is difficult to make a case for another liquidity freeze in the foreseeable future.
    Investors might argue that the global economy is not in the best of shape and bond yields might touch 2012 lows. However, I am of the opinion that growth has bottomed out in several economies globally and might stabilize at these levels or trend higher. With the S&P 500 touching a five-year high, market participants are certainly moving more towards a “risk on” trade than “risk off” trade.
    My point related to the end of the Treasury bull market is further strengthened by the fact that bond yields have been trending higher meaningfully despite the unlimited bond purchase program by the Federal Reserve. One of the primary objectives of the purchase program is to keep yields artificially lower. However, market participants are demanding higher yields as global economic recovery does bring in relatively higher inflation. Yields on the 10-year Treasury bond have surged from a low of 1.4% in July 2012 to over 1.9% currently.
    To add further to the point on inflation and returns for investors, the effective federal fund rate (adjusted for inflation) has been negative since the beginning of the recession in 2008. I do believe that real interest rates will remain negative even if interest rates trend higher over the long term. In other words, inflation might be much more rampant. As such, I would avoid longer-term Treasury bonds and prefer the short-term bonds for trading. The fear of rampant inflation might be in the mind of Fed officials when they suggested a possible end to the asset purchase program in 2013.
    Considering these factors, the Treasury bond yields have bottomed out in all probability in 2012. I don’t expect yields to surge in 2013. Yields will however continue to trend higher, leading to much higher debt servicing cost to the government in the future. From the government’s perspective, higher interest outgo might be offset by payment through a depreciated currency. In other words, financial repression will be a possibility in the future. In any case, inflation will be meaningfully higher, and investors will need to generate much higher returns from their investments in order to preserve their purchasing power.

    The MONEY® Network