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August 9, 2012

Why This “Safe Asset" Could Collapse

By of Wall Street Daily

We’ve written before that U.S. Treasury bonds simply aren’t safe anymore.

Not because the United States will default, but because scared investors have piled into Treasuries, driving up bond prices dramatically.

This can’t go on forever, though. The market – and investors’ appetite for risk – will eventually return to normal. And at that point, this rampant demand for “safety” that’s keeping Treasury bond prices sky high will collapse.
As Louis Basenese said back in March, “Once it’s clear that the U.S. economy is out of the woods… Treasury bond prices are bound to fall, much harder and much faster.”

Did anyone listen to us, though? Apparently not…

Bonds Continue to Be All the Rage

Despite the warning signs, investors seem more addicted to bonds than ever.

According to the latest data from Lipper Fund Flows, investors piled $13.4 billion into bond funds in June.
Even legendary bond investor, Bill Gross – who was predicting a bond collapse for the past year – has started buying.

Plus, the Fed can’t stimulate the economy anymore just by lowering interest rates (since it’s tough to go lower than 0.15%). So the Fed is also buying bonds to drive down long-term interest. And you can bet this will only pick up if the Fed steps in with another round of quantitative easing.

As a result, bond prices continue to surge – which means yields fall.

However, don’t get caught up in the frenzy. Our original assessment hasn’t changed: After the economy recovers, the situation in Europe plays out and the Fed tightens up monetary policy, bond prices will spiral downward.
Besides, there’s another factor boosting bond prices that most investors aren’t talking about – one that’s going to disappear in the next few months.

And when it happens, look out below…

The Treasury’s Keeping a Lid on Debt

In order to buy some time before our debt levels hit the current ceiling, the Treasury is tapping the brakes on bond sales, which has caused debt to deviate from its upward trend.

In other words, the Treasury’s kept the supply of bonds depressed over the last four months, boosting prices even more.

We may not know exactly when investors will get over their fear of risk and begin selling off bonds, but it’s easier to see when the debt ceiling factor will be removed. Even with the Treasury’s interference, U.S. debt will likely hit the current limit around the end of this year.

At that point, the debt ceiling will be raised, the Treasury will increase the amount of bonds offered and prices will fall. It’s that simple.

If that coincides with an increase in investor sentiment, Wall Street’s favorite “safe” asset is going to take a massive tumble.

Or, as Louis said, “Any investors still treating such bonds as a safe investment could be in store for a very nasty – and costly – surprise.”

Courtesy Mathew Weinschenk at Wall Street Daily (EconMatters author archive here)

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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