Bet on Bonds

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Photo-Illustration for TIME by Nilanjan Das; Uncle Sam: Getty Images

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During his recent confirmation hearings, Timothy Geithner, the new U.S. Treasury Secretary, described China as a "currency manipulator." Like all politicians, he qualified his statement with various good wishes toward the Chinese, but the damage was quickly done. Markets began to wonder if China would retaliate by scaling back its massive purchases of U.S. government debt, contributing to a 70-basis-point sell-off in 10-year U.S. Treasury bonds between Jan. 26 and Feb. 4.

Geithner's utterance caused interest rates to jump, costing prospective American homeowners (and many that were seeking to refinance existing mortgages) around 10% more in interest charges. Making home loans more expensive is not a great way to get the housing market moving — nor is it a great way to instill confidence in debt markets. The sell-off quelled a major rally in Treasuries as investors who had been flocking to the safe haven of government paper amid the global recession questioned whether Treasuries had become too expensive. In the last four months of 2008, yields (which decline as prices rise) dropped from 4% to a low of 2.25%.

But the rally isn't over. The fear that China will stop buying U.S. debt is unfounded. Beijing can't buy anything else with its excess dollars. There are simply no alternative investments that are large enough or liquid enough. But more importantly, there are fundamental reasons why Treasury prices will move much higher (and yields lower) — and why the current opportunity to go long U.S. Treasuries should be grasped with both hands.

There are two aspects of the ongoing recession that may come as a surprise to some observers as events unfold. The first will be the failure of central banks to re-ignite credit growth in the ailing banking system. The second will be the failure of governments' debt expansions to increase the cost of funding. In other words, the long end of the yield curve will continue to be depressed, just as it has been in Japan for the past 16 years. In the early 1990s observers in Japan argued that 10-year Japan government-bond yields of 3.5% could not persist for long. That was when the government debt-to-GDP ratio was around 50%. It now stands at 150% and 10-year yields are 1.36% (having gone as low as 60 basis points in the interim).

In our view, yields on U.S. 10-year Treasury notes will fall to between 1.5% and 2% by the end of 2009. This is because the banks are broken and their customers are keen to spend less. The monetary base, the money element that the Fed can control, is a fraction of credit outstanding in the U.S. system ($2 trillion versus $47 trillion). No matter how fast base money is pumped up, the reduction in credit outstanding will overwhelm it. During this phase we should expect credit contraction and its attendant deflationary effects on asset prices and consumer goods and services.

Yields are also bound to go lower because demand for U.S. government debt will easily match supply, even though Washington must sell hundreds of billions of dollars in bonds in coming months to fund stimulus measures and bank rescues. Consider the uncanny parallel between the composition of assets on bank balance sheets in 1929 and balance sheets at the start of this crisis. The ratio of loans to investments, which include Treasuries and other securities, was 2.6:1 in 1929 and 2.8:1 in 2008. During the early period of the Great Depression, banks restructured their balance sheets to reflect a much more conservative lending stance. They reduced loans — in absolute and relative terms — and increased investments in safe assets, mostly Treasuries.

Of course, there are major differences between today's banking and monetary systems and those of the 1930s, but the one constant is human behavior. Personal balance sheets, corporate balance sheets and bank balance sheets will inexorably move into safer instruments given the wealth destruction that has occurred in riskier assets over the past year (and which will continue for the foreseeable future). If the banking sector alone were to move toward its more conservative 1935 ratios, then the increased demand for government paper from that source alone would be $700 billion.

It's likely that shifts in household and corporate investment patterns will produce even greater demand — which is why U.S. 10-year notes remain attractive, not for their paltry yield but for their capital-gain potential. The next bull market will be concentrated in government paper — even as confidence in government itself erodes.

— Jim Walker is the founder and CEO of Asianomics Limited, a Hong Kong consulting and economic-research company