Why Investors Are Still Running to U.S. Treasuries; Why It Could Be a Big Mistake

Why Investors Are Still Running to U.S. Treasuries; Why It Could Be a Big MistakeWith fears of the fiscal cliff looming in the U.S. economy, investors are flocking towards the “safety” of U.S. bonds. But the yield on the U.S. bonds is zero or less when you consider the inflation rate.

So why are investors running to U.S. Treasury bills? In general, investors are risk-averse right now—they don’t like risk. They would rather buy investments or securities that return their principal. It’s a given that when the risk rises, or uncertainty increases, investors run toward safer investments—simply waiting and looking for other buying opportunities.

This is exactly what we are seeing in the U.S. economy. There is a rush to buy U.S. bonds, which is causing the yields to decline. For example, 10-year U.S. bonds are yielding 1.6%. The chart below shows you the precise picture.

TNX 10 Year Treasury Note Yield INSX

Chart courtesy of www.StockCharts.com

The 30-year U.S. bonds are in the same situation—yielding 2.8% and declining. The following is the chart of the yield of the 30-year U.S. bonds.

TYX 30 Year t Bond Yield INDX Stock Market

Chart courtesy of www.StockCharts.com

When looking at these charts, keep in mind that the most basic reason bond yields fall is that their prices are going up.

Some may argue that the yields of the U.S. bonds are falling because the Federal Reserve is buying long-term bonds to keep the interest rates low. Through Operation Twist, the Federal Reserve’s plan was to buy a total $667 billion in long-term U.S. bonds and sell short-term U.S. bonds. (Source: Federal Reserve, June 20, 2012.)

Its reasoning makes sense, but it’s not only the Federal Reserve that is buying these bonds. Long-term bond mutual funds in the U.S. economy have been seeing an influx of funds pouring into them. For the week ending October 31, $2.6 billion was parked in bond funds. There has been a continuous flow of money coming into bond funds since the beginning of this year. (Source: Investment Company Institute, November 7, 2012.) Comparatively, equity mutual funds have been seeing an outflow of funds.

It’s not rocket science; there is a significant amount of risk present in the U.S. economy, and that’s why investors are going toward “safer” U.S. bonds. If the fiscal cliff does occur, we will be heading for a darker period in the U.S. economy, with more investors running to U.S. bonds. So the short-term picture for U.S. bonds still looks good.

But for the long-term, I see a very different picture. I believe inflation will be a big problem over the next couple of years. If inflation is really running at four to five percent a year (forget what the antiquated Consumer Price Index numbers tell you), investors are experiencing negative returns with U.S. bonds.

Next, if the U.S. is not able to aggressively raise taxes and lower government spending (which I believe it will not be able to achieve), the U.S. national debt will just continue to grow through the year 2020—at which point our debt-to-gross domestic product (GDP) ratio will be way out of whack. Thus, the Fed will have the next seven years to print more money to cover the government’s annul debt obligations. At that point in the U.S. economy (which could be much sooner than 2020), when investors really figure out the government is simply repaying debt via massive amounts of newly printed money, U.S. bonds will need to offer sharply higher yields to attract investors to them. And yes, that’s when the U.S. bond market could burst.