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Bubble Trouble

Is the U.S. Treasury Market About to Pop?

When Elisabeth Kübler-Ross penned her 1973 book On Death and Dying — which identifies the five stages of grief as denial, anger, bargaining, depression and acceptance — she was concerned about cancer patients and their loved ones, not the psychology of shock-weary investors who have watched a financial meltdown infect world economies and bleed billions from their savings and portfolios.

But grief, it turns out, follows much the same curve regardless of what has been lost. From the onset of the subprime credit crisis in mid-2007 until the autumn of 2008 when the teetering house of financial cards finally collapsed, most investors were in denial. Experts now say they knew all along that the system was overleveraged and something about mortgage-backed securities smelled bad. But they originally told themselves that the global economy remained fundamentally sound and that a recession, should it even come to that, would probably be shallow and short. They expected markets to react accordingly.

That period of wishful thinking was followed by anger. It was directed at everyone from former Fed chief Alan Green

Investors from around the world, alarmed by volatile financial markets and a fast-spreading recession, have been pouring money into the U.S. Treasury market at astounding rates since July. Prices are at record highs and yields have reached new lows. On December 9, four-week Treasury bills sold at a yield of zero percent at an auction. That same day, the yield on three-month bills briefly turned negative in the secondary market, leading some economists to warn that the next great investment bubble may be forming in the Treasury market.

"Bubbles are always caused by cheap and ample credit. If so, then the next bubble will be in Big Government, since the Treasury is able to borrow huge sums at near-zero interest rates," independent economist and investment strategist Edward Yardeni warned in a December 15 letter to clients.

Prices for Treasury debt are high, even though supply is at an all-time high. The U.S. government has been issuing unprecedented amounts of debt to recapitalize troubled banks, buy illiquid securities clogging up the credit markets and stimulate the economy. But in doing so, it runs the risk that its own debt loses its triple-A luster. That could lead to higher borrowing costs, which in turn could lead to a deeper recession or even a depression. "The risk of violent price declines in U.S. Treasuries is a real risk, even if it’s not a big one," says Steve Persky, co-founder and CEO of Dalton Investments, a Los Angeles–based hedge fund with $800 million under management.

That would be disastrous, possibly leading to an Argentina-like default at the national level. In fact, the price of credit default swaps on Treasury debt has increased, indicating that investors are taking the possibility of a U.S. government default more seriously. The price of a CDS on a five-year Treasury note was 67 basis points on December 19, up from 6.8 basis points at the beginning of 2008. That’s higher than the cost of insuring other sovereign debt. A CDS on Japanese government debt is about 40 basis points, up from 20 basis points at the beginning of 2008. Insurance on French and German debt is cheaper than U.S. insurance as well.

Determined to revive a deeply troubled economy, the U.S. government has extended bailouts that could top $4 tril-

lion, according to Mustafa Chowdhury, head of U.S. rates strategy at Deutsche Bank. The Treasury has already spent $350 billion through the Troubled Asset Relief Program and an additional $48 billion on the purchase of mortgage-backed securities, he says. It could spend an additional $350 billion through TARP, a vehicle for buying up illiquid securities. The Federal Reserve is enmeshed in $3 trillion worth of bailouts for a critical list that runs the gamut from insurer American International Group to the market for commercial paper, Chowdhury says.

To support these programs, the Treasury department has issued debt at a historic pace. The size of the market grew by $1.25 trillion over the 12 months through November, to $6.4 trillion, according to Chowdhury. He says the market could grow more than $1 trillion in 2009, as the Obama administration embarks upon a fiscal stimulus plan worth an estimated $850 billion. "We’ve never seen anything like this. Every Treasury rate auction is of record size," Chowdhury says.

The basic laws of economics tell us that the price of a product should drop as supply increases. The Treasury market isn’t behaving that way, though. Treasury prices have spiked higher, and their yields, which move in the opposite direction, have dropped to record lows despite rising supply. On December 24, for example, the Treasury auctioned off five-year T-bills with a record low yield of 1.54 percent, down from 3.65 percent a year ago. The auction raised a stunning $28 billion, twice as much as comparable auctions in 2007. How can that be? Collapsing confidence in financial institutions and a global economic recession have compelled investors to find a safe haven for their cash, and U.S. Treasuries are still perceived as the ultimate safe haven. "The U.S. government’s fiscal initiatives should be pushing Treasury yields higher. At the same time, there’s a global flight-to-quality trade, because the risk premium globally is increasing. In the tug of war between these two forces, so far the risk-premium trade is winning," Chowdhury says, adding that the current market dynamic is unsustainable.

The critical question, then, is how long can the health of the U.S. Treasury market be sustained? The run-up in Treasury prices looks a lot like the bubbles that appeared in the housing and stock markets. Eventually those bubbles burst, shattering market values and wreaking financial havoc that spread around the world.

Yet some say the Treasury market can avoid a similar fate: It’s backed by the full faith and credit of the U.S. government, which has the power to print money to pay off its debts. In normal times, that would be a recipe for inflation. It appears to be avoiding that problem for now, because other markets around the world have fared even worse than the U.S. has. The stock market in Shanghai has fallen more than 60 percent, Chowdhury notes. As long as the U.S. fares better, investors will favor dollar-denominated assets, and Treasuries in particular, keeping inflation low, according to Chowdhury.

"But once the bailouts gain some traction interest rates are going to rise" because of inflationary fears, Chowdhury explains. In fact, the yield curve already is steepening, a sign that investors have longer-term worries about inflation. The yield on the 30-year bond rose to 2.98 percent on January 5, up from a record low of 2.52 percent just three weeks earlier. If interest rates surge during 2009, they could flatten the economy just as it is struggling to get back on its feet, prolonging and deepening the recession. As bad as the downturn feels, the recovery might be worse.

span for keeping rates too low for too long, to Wall Street CEOs for tossing out false assurances, to short-sellers for betting that things would get worse. "People were seeing things they’ve never seen before, and they were trying to figure out the world, but they couldn’t," says Meir Statman, who teaches finance at Santa Clara University in California.

Bargaining came in the form of bailouts and the belief that the government’s cash injections, infrastructure spending and 0 percent rates might actually right the ship. This desperate clinging to hope for a quick turnaround led to a nausea-inducing rollercoaster ride in the stock markets in the last quarter of 2008 and sent the Chicago Board Options Exchange’s volatility index, known as the VIX or "fear gauge," which usually hovers in the teens and 20s, to well above 80.

But haggling is exhausting, and was soon replaced by depression. Applied to the current crisis it looks a lot like a bad case of buyer’s remorse — people are realizing the full extent of the federal government’s financial obligations, and they’re feeling a bit sick about it.

Some people are stuck in depression, but Statman says most have moved on to acceptance. "People see that the money is gone and that it’s time to let go. They realize they are in this new world now, they’ve sustained this loss, and they’re saying, ‘I can’t let it dominate my life anymore, I have to find practical solutions.’"

As if on cue, the VIX index, which measures the cost of using options to insure against big drops in the Standard and Poor’s 500 index, dipped below 40 in early January. "There is a sense we’ve moved away from panic and into calm," says Statman. "The fundamentals aren’t better but I think there’s a feeling that all the shoes dropped, which really says that sometimes, just not having bad news is good news."