The thirty year party is about to end.
U.S. Treasury debt is a financial asset, unique in that it is backed by the full faith and credit of the U.S. Government, historically making it a low-risk investment compared to most other financial assets.
The 10-year Treasury Note yield is the source of much attention because it establishes the bottom for mortgage loans interest rates. It is the interest rate bellwether.
Why do investors buy treasury debt? Short term treasury debt is particularly good for safely storing and preserve wealth, even better than cash for large amounts that exceed FDIC insurance limits. But many investors actively trade treasury debt to earn wealth.
How to earn wealth from a treasury debt investment? To do so one needs to beat inflation, which according to the CPI in 2020 was 1.2%. A challenge in that all treasury debt in 2020, for 10-year and shorter duration, had a yield less 1.2%. Thus, if this treasury debt were held to term, it is like holding cash, a low-risk way to gradually lose wealth.
Given this gradual loss of wealth, why the investor demand for treasury debt? Because like all other financial assets, the price of treasury debt varies day to day, providing investors the opportunity to buy low and sell high. The price of any debt is inverse to the interest rate, so as interest rates drop, the price of a debt goes up. So rather than holding the treasury debt to maturity, guaranteeing a loss of wealth, the astute investor sells it for a profit before maturity, realizing a wealth profit. Only works if interest rates have decreased.
The U.S. Treasury Debt market is unique in that it has a massive fly-wheel function, namely the Federal Reserve. With its nearly infinite capacity for creating or absorbing dollars, the Federal Reserve can choose to create artificial demand or artificial supply of treasury debt on the open market.
For the last 30 years the Federal Reserve has for the most part created artificial demand, which depending on the supply response, can have one of two effects:
- If this pumped-up demand exceeds supply, the price of the treasury debt will increase, rewarding the investors that choose to sell at that time. The yields will of course proportionally decrease.
- If the supply of treasury debt also increases, this would cancel the increase in demand, and the price & yield would remain constant. This increase in treasury debt supply would come from the U.S. Treasury. How else do you think our government plans on operating with a trillion-dollar deficit?
For the last 30 years the Federal Reserve has been creating excess dollars, using them to create artificial demand for treasury debt, pushing down interest rates while allowing our government to borrow more.
And of course, this keeps the rate of inflation above zero, gradually devaluing the dollar, transferring wealth from holders of dollars to the Treasury.
All while rewarding those investors that choose not to “fight the fed”. They kept buying treasury debt, selling every time interest rates dropped, realizing a quick profit.
Will this party ever end?
It will, and the first sign of trouble will be increase in the 10-year treasury yield.
This first graph highlights the 30-year party, a gradual, Federal Reserve induced reduction of the 10-year yield, accompanied by an increase in the Monetary Base and of course continuous inflation.
Now take a closer look at the 10-year yield over just the last year.
Note that for the second half of 2020 the 10-year treasury yield has been gradually increasing, meaning that the price of this note has been gradually decreasing. Playing the “buy the treasury debt today and sell it later for a quick & easy profit” game has not been working so well lately. Did you really think that yields would drop below zero?
And what about that little uptick for January of 2021? What would cause such a sell-off of treasuries, other than of course, investors believing that it is better to sell today than to sell tomorrow.
Recall that holding most treasury debt to maturity is already a wealth losing strategy even with inflation at a low 1.2%. The wealth losses will only increase if the rate of inflation were to increase, increasing the spread between inflation rate and the treasury yields.
If inflation were to significantly increase, it should be expected that demand for treasury debt, and all other debt, will drop like a rock.
Someone just turned off the music.
No problem, the Federal Reserve will continue the 30-year party by creating even more dollars, with the understanding that they will be used to purchases more treasury debt, making up for this “temporary” drop in demand. This action of increasing the artificial demand will of course increase the price and lower the yields.
And how conveniently, allows our government to increase the deficit.
Hold on. Will this not exasperate the problem by increasing the spread between the rate of inflation, and the treasury yields? Yes, it will backfire, as no logical investor will choose to lose that much wealth, meaning that the only entities left purchasing treasury debt will be the banks receiving the newly created dollars from the Federal Reserve.
All pretense of the treasury yields being set be an open market can be forgotten, and a massive increase in the money supply will follow, which has proven to be a long-term inflationary force.
Things appear to be moving in the wrong direction, as no one likes high inflation.
Perhaps instead the Federal Reserve should reverse course and instruct its bank minions to sell their treasury debt holdings for dollars, returning those dollars to the Federal Reserve so that they can be sent off to financial purgatory. The result being a reduction of the money supply, a long-term deflationary force. Flooding the market with this treasury debt will increase the supply relative to demand, lowering the price, and increasing interest rates.
Hold on again. Will not increasing the interest rates be bad for the economy? How many times have you heard this from the talking heads on the financial news feeds? The truth is that the effect on the economy will be mixed. The savers will be rewarded, those that need to borrow will be punished.
The only problem being that the greatest borrower of them all is the U.S. Government.
Party on Wayne.
And keep an eye on the 10-year treasury yield.
Want to learn more?