Are Treasuries in a Bubble?

The latest asset class to don the dreaded "bubble" cloak has been the U.S. Treasury market. As of this writing, the yield on the 10-year bond had dropped to 2.65%, a level that hasn't been seen since 1954. What makes this bit of trivia notable was that immediately following this period, the United States experienced one and a half to two years of deflation. This was also the last time that we had actual deflation in the U.S.

So what does all this mean? In terms of performance it means that year to date, the top-performing non-short exchange-traded fund is  iShares Lehman 20+ Year Treasury Bond (TLT). What the fund has given up in yield over the past year, it has certainly made up for with its 23% capital appreciation. As a quick refresher: When bond yields go down, their prices go up.

Before investors start trying to poke holes in a bubble, however, they need to understand what is behind it in the first place. In what is clearly an oversimplification, there are three primary drivers of Treasury yields. The first two form the most basic interpretation of the Treasury yield: the expected rate of inflation and the real risk-free rate of return. In theory, investors can dissect the yield by looking at the spread between the 10-year Treasury Inflation-Protected Security bonds (TIPS) and the 10-year Treasury. Right now that stands at a meager 0.61%, meaning that the market is essentially expecting almost no inflation over the next 10 years. This also tells us that the accepted real risk-free return in the market is only 2.02%.

So, one piece of the Treasury bubble decision is clear. If you think that the U.S. is going to experience deflation over the next few years, then a 2% return might actually seem reasonable. In fact, you will be getting paid for inflation risk that you don't believe exists while the prices of all other assets continue to drop. Opponents to this line of thinking would point out that the Treasury has been printing money at an alarming rate trying to reflate the economy and that eventually the bill will need to be paid in the form of inflation.

It is hard to argue with that Keynesian rationale, but let's put it aside for a moment and look at the third driver of Treasury yields. The final piece of the Treasury puzzle is demand for U.S. dollars. More specifically, the demand for U.S. dollars that are free from credit default risk. Treasuries play an important role in the zero-sum game that is currency arbitrage. As demand for U.S. dollars goes up, Treasury yields drop and the demand for other currencies also drops.

In short, the dollar exchange rate and the Treasury rate are inexorably linked. In order to burst the Treasury bubble, one would need to identify the currencies or other economies that are going to rise as the dollar sinks. Will it be the euro? Maybe the yen? The Chinese yuan or Aussie dollar? Well, outside of the yen, the majority of global currencies have been tanking against the dollar. I would even propose that given this closed-loop system and the state of the global economy, banking on the any of the economies to improve ahead of the U.S. is unlikely. One thing seems apparent: We managed to export our problems to such a significant degree that we managed to put almost every other economy in a hole that is as deep as ours--usually deeper. Really, the biggest threat to the dollar we see is the potential for wholesale dumping by the Chinese government of their billions of Treasuries. That is a topic for another time, but the consequences would be dire if this occurred.

There is an escape hatch, however, that will allow money to leave Treasuries and not necessarily cramp the dollar. If investors were to regain their risk appetite and start buying riskier assets in the U.S. such as stocks, corporate bonds, and real estate, then we could see Treasury rates rise. The resultant rise would in theory reflect an increase in the risk-free rate component of the bond yield as investors would demand more and more return for their cash.

Inflation, the risk-free rate, and dollar demand are all highly interrelated with multiple forces acting simultaneously on each of the primary drivers. (Again, I said at the beginning of this discussion that I was trying to keep things simple.)

Still, I think that the important takeaway for anyone thinking that the Treasury market is in a bubble is to understand what will cause it to burst. Either the expectations for inflation will increase, the dollar will fall vis-a-vis other currencies, or investors will get their appetite for risk back. Of course, for those thinking about shorting Treasuries, the "when" becomes almost as important as the "why." So keep the timing of these events in mind as you make your bets.

Personally, I think the Treasury market is a little frothy right now--especially in the longer-dated tranches. But, I won't go so far as to say that it is a bubble ready to burst. We are still looking at falling asset prices for the next few quarters and other countries are dealing with the same issues that plague the U.S. I think the most likely escape valve for the built-up pressure in the Treasury market lies with investors regaining their appetite for risk. After all, nobody is really happy with a 10-year expected return that is less than 3%.

Let us know what you think about the Treasury market on our ETF Forum page at this discussion thread.  

		ETFInvestor Newsletter
	Let our new newsletter, Morningstar ETFInvestor, help you navigate the exciting and new world of exchange-traded funds. Each issue includes recommendations for commonsense ETF investing,		ETF spotlights, and critical data on 150 top ETFs. This one-year subscription consists of 12 monthly issues. Learn more.
	$149.00 for 12 Print Issues		$129 for 12 PDF Issues