The Federal Goverment Spending Spree Continues

by messay.com

2008 may well be remembered as the year when Treasury Secretary Henry M. Paulson Jr. stole the show from the Fed’s Ben Bernanke.  The year when investing in US Treasuries seemed to be the only safe place to run.  “IS YOUR MONEY SAFE?” was the media sound bite and the only thing safe enough was the “full faith and credit of the US Government.”  The possibility of even the mighty FDIC going kaput gave nightmares of bank runs and CD defaults.  So how safe exactly is investing in treasuries?  That answer depends on your definition of safe and which type of treasury you buy.  As this article will show, there have been times when certain treasury investments have produced significant negative returns. 

The United States Department of the Treasury issues four types of marketable securities and several non-marketable securities.  This article will only be concentrating on the T-Bill, T-Note and the T-Bond.  All 3 are free of market risk only if you are willing to hold them to maturity.  If you purchase an individual treasury and sell it before it matures, you run the risk of selling if for less than you paid for it, i.e. Market Risk.  One contributor to the market risk is simply the transaction cost of buying and selling.  Avoiding market risk and transaction costs are two primary reasons why you may wish to hold treasury investments until maturity instead of jumping in and out.

T-Bill: Almost Risk Free

The safest of the safe is the T-Bill which is issued with a maturity of less than 1 year, commonly 3 or 6 months.  As of Dec 19th 2008, the 3mo T-Bill was yielding 0.0% interest.  This is far below the long-term average of 3.5%.  This clearly illustrates that investors are more worried about loss of capital than rate of return.  Of course, the worst one year return for T-Bills in history is 1% which is great news when return of principal is the only concern.  But T-Bills are not completely risk free when we consider inflation.  This explains why the worst 1-year, real return is -8.8% occurring in 1941.  Figure 1 illustrates the US inflation rate from 1914 through 1998 and is included here to provide a sense of how much inflation can change in a very short period of time.  It is important to recognize that 1941 was not the year with the highest inflation rate on record, but a year following a period when no one cared about inflation.  So again, T-Bills can be considered relatively risk-free for your capital, but that doesn’t mean that they should be considered risk-free to you.      

Figure 1: Data from the Bureau of Labor Statistics

T-Note & T-Bond: A Risky Asset Class

The most commonly quoted treasuries are the T-Note and T-Bond and this is where the concept of risk-free really breaks down.  T-Notes are issued with maturities from 2 to 10 years and T-Bonds can be issued with a maturity up to 30 years.  As with the T-Bill, both the T-Note and the T-Bond bear no market risk if you hold them to maturity.  But with the 10 yr T-Note yielding 2.08% and the 30 yr T-Bond yielding 2.56%, I wonder how many investors are truly planning and capable of holding them until maturity.  I would wager that most individual investors do not hold today any securities that they purchased 10 years ago.  Most get bored or lose faith and change their investments every couple of years which introduces market risk, the risk of selling the investment at a loss.  Also, as time passes, the T-Note and T-Bond will be subject to pricing pressure.  For example, the worst 1yr return for the T-Bond in history is a -9% which occurred in 1999.  When you include inflation, the worst T-Bond real return was -15.46% occurring in 1946.  These numbers hardly support the claim that the T-Note or T-Bond is risk-free.  Both are yielding close to their all time lows.  For example, Figure 2 illustrates this point for the 10 yr T-Note going back to 1964 and clearly shows that today’s yield is very close to the all time low of 3.09% in 2003 and significantly lower than the high of 15.84% set in 1981.  Additionally, the 10 yr T-Note today is yielding 1.0% less than the year-over-year core inflation for Sept 2008 which was 4.94%. This means investing in the 10yr T-Note is a guaranteed loss if the annual rate of annual inflation continues.  By way of comparison, investors were demanding a 5% yield over annual CPI in 1995.  So both the T-Note and T-Bond would appear to have significant downside risk from inflation moving forward.

Figure 2:  

How bad can it really get in treasuries?

What would cause the supply of treasuries to increase more than demand?  After all, price and yield is simply based on supply and demand.  Currently the supply of treasuries is increasing but not as fast as demand, so yields have fallen and prices have risen.  What happens if demand contracts?  Well perhaps it is important to recognize that in 2007 57% of all US treasuries were owned by foreigners compared to only 12% in 1978 and 35% in 2000.  In 2007, China owned 22% and Japan owned 29% of all US treasuries.  What would cause foreign governments to sell or reduce their appetite for US treasuries?  Foreign governments typically hold US treasuries to help control their currency or more accurately, to “defend” against currency devaluations.  In times of crisis, they can sell their US dollar treasuries to try and defend their currency from extreme devaluations against the dollar.  This occurred in 1997 as Brazil, Russia and the Asia Tigers defended their currency from the devastating currency devaluations at that time.  In Nov 2005, the Federal Reserve Board of San Francisco released a study containing this line:  “If the sale of dollar-denominated reserves took the form of a sale of US treasury securities, then the price of these securities would decrease”.  So prices can decline if foreigners sell the Treasuries or just simply buy fewer.  Remember, treasury bond supplies are going up so demand must increase at the same rate or faster or else prices will fall.

Besides foreign demand wavering, another scenario which may cause treasury prices to fall is simply inflation increasing to 7% or even 10%.  This may seem far fetched but no more far fetched than predicting that AIG, Freddie Mac, Fannie Mae, Lehman, WAMU and Wachovia all would be gone.  It might not be very probable that CPI will rise to 7% over the next year, but it is absolutely possible.  Will it?  I don’t know.  But I do know that at today’s treasury yields, prices have more downside than upside.  Even if the Fed Target Rate drops from 0.5% to 0.0%, how much farther down can treasury yields go?  Will investors accept negative nominal rates in addition to negative real rates?  If that is the world you really expect to unfold, you might wish to forget buying treasury for safety and go directly to guns and gold. 

Inflation, The Silent Killer

You no doubt are tired of me mentioning inflation.  Perhaps many of you are asking why you should care about inflation when world stock markets have crumbled over 30%, corporate bonds have lost over 20% and even municipal bonds have lost around 10%.  The last thing you and most other people care about right now is inflation.  And that is the point; it is the risk you care least about that leads you to accept the lowest premium for accepting it.  Today, people are asking no return for accepting the risk of inflation.  It is the punch that you don’t see coming that lays you flat.  Whether we are immediately facing inflation, deflation, hyper-inflation, or average inflation is anyone’s guess.  But in the next 2, 5, 10 or 30 years, I have to believe it will be closer to the long-term average of 3%.  One further item I would like to include about inflation is that the Social Security COLA adjustment for 2009 is 5.8%.  This is the largest adjustment since 1982 and compares to the 2007 adjustment of 2.3% which was the lowest since 2003.  This further should show just how real inflation is and how quickly it can dramatically change.

Look before you Leap

Today, treasury yields are at all time lows which means treasury prices are also at all time record highs.  So moving to T-Notes and T-Bonds may be moving from the frying pan into the fire.  T-Bills could be the deep end of the pool where investors drown under inflation.  Of course, I was recently reminded that in times of panic, people only care about the return of their capital, not the return on their capital.  But please remember that stock market peaks occur when everything is “priced to perfection”, so the slightest disappointment can lead to a dramatic fall.  The opposite, mirror reflection is also true for treasuries which today might be “priced for depression”.  The pendulum has swung to the far side of negativity so the slightest bit of good news could lead to the treasuries fall from glory. 

In conclusion, treasury securities never were, never are and never will be completely risk free.  They maybe close, but close only counts with horse shoes and hand grenades. 

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Question by Mr J: US Treasury??????????????????????????????
What is the most common use of money made by the US treasury?????????????????????????????????

Best answer:

Answer by Ryan
It is typically used to finance government spending.

However the treasury does not make money. The federal reserve (central bank) does.

However since the central bank is obligated to purchase treasury bonds, the treasury simply sells the bonds to the central bank (which the central bank has to make money to buy). This produces money extra money and extra money for the treasury.

Give your answer to this question below!
US Treasury Plans 2 Big Sales Of AIG Stock In 2011 -Reuters
US Treasury Plans 2 Big Sales Of AIG Stock In 2011 -Reuters
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