Treasurys: A Catch-22 for Investors

Thursday, 31 May 2012 08:14 AM

By Jacob Wolinsky

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Bond yields on 10-year US Treasurys have fallen to a level unseen since 1946. The 10-year Treasury, commonly called the 10 year, hit a yield of 1.62 percent.

The reason isn't that investors think this is a good return, but they are scared of all other investments in light of the dire scenario which Europe finds itself in.

The latest fear is about Spain and upcoming Greek elections, in which the victorious party may override current bailout agreements for Greece.

However, barring the United States facing a Japan-type deflationary recession, Treasurys are an awful bet.

Ben Bernanke, the chairman of the Federal Reserve, has a target inflation rate of 2 percent. That means investors buying government bonds will lose money if inflation is 2 percent.

The truth is that due to the large fiscal and monetary stimuli, the rate of inflation is likely to be higher. Investors on an after-tax basis are already earning close to nothing at a yield of 1.62 percent. After inflation of 3 percent or more, investors will have huge losses.

Does that mean investors should short 10-year Treasurys? That might also be a dangerous play as well.

America could experience a Japanese-style depression where yields have been around 1 percent for years. That would mean a big loss for people who are short the bonds.

This scenario is unlikely as President Barack Obama is boosting spending on anything that can buy him votes. Bernanke is increasing the money supply to prevent another Great Depression. Therefore, it is likely that inflation will be on the horizon sometime in the future.

So does that make shorting Treasurys a good bet? Again, not necessarily.

The Federal Reserve controls interest rates and has de-facto control over Treasury yields. If Treasury yields get too high, the Federal Reserve can buy Treasurys to lower the yield, which increases the value of the bond.

The media often misses this point and gets worried when Treasury yields rise as they did during a brief period in 2011. The fear is silly because Bernanke practically decides what the securities will yield.

As the saying goes, "Don’t fight the Fed." So too here, shorting Treasurys would be a fight against the Fed.

For investors looking to park some money they don't plan to touch, short-term Treasury index funds might be a good option. Despite the low yield, they do offer safety. However, buying long-term Treasurys to short or to hold to maturity is dangerous. It is also very risky and offers a low possible return.

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