In their understandably concerned state of mind in the present day, investors may have lost sight of the longer-term drivers of asset prices. Bonds, especially U.S. Treasuries, have merit presently as high levels of debt have sparked concerns about deflation. However, in the long-run, the case for stocks, commodities, commodity-related currencies, and precious metals looks quite a bit stronger than the case for bonds.
In the current 24-hour news cycle, we have three separate stories that are significantly intertwined and related to this topic:
- According to the Washington Post, the Obama administration opened its conference on the future of housing policy yesterday with Treasury Secretary Tim Geithner promising both an overhaul of Fannie and Freddie and a continued federal role in backstopping mortgages
- James Bullard of the St Louis Fed told The Wall Street Journal the Federal Reserve might need to commence a program of moderate purchases of U.S. Treasury bonds if inflation continues to fall.
- In the Great American Bond Bubble (WSJ), Jeremy Siegel and Jeremy Schwartz, compare the current state of the U.S. Treasury market to the tech bubble of the late 1990s.
The long-term outlook for U.S. Treasury bonds is questionable at best, yet investors continue to make bigger and bigger bets on government IOUs. Earlier this year, the Congressional Budget Office (CBO) said the government faces a “daunting” fiscal future. Federal budget deficits will average $600 billion over the next decade, according to CBO’s outlook. “U.S. fiscal policy is on an unsustainable path to an extent that cannot be solved by minor tinkering,” said CBO Director Douglas Elmendorf.
Despite the “daunting” and “unsustainable” state of the government’s finances, Tim Geithner’s comments yesterday gave no indication taxpayers would be leaving the cash-draining mortgage business anytime soon. In the end, losses at Fannie and Freddie related to the financial crisis may cost taxpayers $305 billion, according to one estimate recently published by Mr. Zandi and Alan Blinder of Princeton University.
The further we go out into the future, the higher the probability the government will turn to the printing press, which is not good news for longer-term inflation rates, nor holders of U.S. Treasuries. Recent policy moves by the Fed and James Bullard’s paper making the case for further quantitative easing signal to the markets the Fed is willing to print more money if needed.
Treasury bonds may have appeal in the short-to-intermediate-term as markets wrestle with deflationary forces. However, do bond holders really believe the political will exists today, or will suddenly surface in the future, to address the “unsustainable” state of U.S. financial affairs? It is much easier to print money than to cut budgets or raise taxes. The U.S. will be forced to make some hard decisions related to spending and taxes, but you can bet money printing will be part the equation in the foreseeable future.
The harsh reality we are faced with prompted Warren Buffet to remark:
A country that continuously expands its debt as a percentage of GDP and raises much of the money abroad to finance that, at some point, it’s going to inflate its way out of the burden of that debt.
Not only are the long-term fundamentals unattractive for holders of U.S. debt, but valuations are also prompting comparisons to the tech bubble of the late 1990s. From this morning’s opinion page in the Wall Street Journal (The Great American Bond Bubble, Siegel and Schwartz, 08/18/2010):
- A similar bubble is expanding today that may have far more serious consequences for investors. It is in bonds. Investors, disenchanted with the stock market, have been pouring money into bond funds.
- We believe what is happening today is the flip side of what happened in 2000. Just as investors were too enthusiastic then about the growth prospects in the economy, many investors today are far too pessimistic.
- The rush into bonds has been so strong that last week the yield on 10-year Treasury Inflation-Protected Securities (TIPS) fell below 1%, where it remains today. This means that this bond, like its tech counterparts a decade ago, is currently selling at more than 100 times its projected payout.
- Those who are now crowding into bonds and bond funds are courting disaster.
- If rates rise to 4% as they did last spring, the capital loss will be more than three times the current yield. Is there any doubt that interest rates will rise over the next two decades as the baby boomers retire and the enormous government entitlement programs kick into gear?
In Stocks Continue to Walk a Fine Bull-Bear Line, we acknowledge the short-to-intermediate term outlook for stocks, and risk in general, remains bullish, but very fragile. Longer-term, the fragility of the bullish outlook for stocks, commodities, and precious metals will probably be strengthened by macro forces that point in the direction of money printing and inflationary outcomes. Therefore, an investor should keep oil, copper, gold, silver, the Australian dollar, Canadian dollar, and commodity-related stocks on their long-term radar.
This article contains the current opinions of the author but not necessarily those of CCM. The opinions are subject to change without notice. This article is distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product.
