Treasuries May be no Safe Haven in This Stock Market Storm

By Martin Hutchinson
Contributing Editor

For the last couple of years, every time problems have emerged in the stock market, investors have rushed into U.S. Treasury Bonds, assuming they're a catchall "safe haven" against stock-market storms.

But there are signs that at least long-term Treasuries may no longer provide that safe haven - and actually may pose the danger of substantial capital losses.

The reason for this is very simple: The financial markets think inflation is on the way back.

Earlier this week, I detailed the problems faced by the Korean steel manufacturing company Posco (PKX) when the cost of iron ore, its principal raw material, suddenly rose 65%. That problem is repeated throughout the economy. For example, winter wheat prices have risen 90% in the last 6 weeks. That can't help but have a damaging impact. Just look at bread producers. These companies are used to dealing with fluctuations in wheat prices, and averaging out the profits with the losses, but they can't average out a fluctuation of that size. Consequently, bread prices too will have to rise.

This is no longer a matter of just one commodity, oil, being forced up in price due to special factors; commodity prices in many different market sectors are rising in many different geographic markets - and all at the same time.

No amount of fudging and looking at only "core" inflation is going to be able to disguise this very painful reality: Inflation is on its way back - with a vengeance - and will be very difficult to get rid of again.

Until recently, U.S. Treasuries were ignoring this possibility. The collapse of the subprime-mortgage market, and the resultant difficulties suffered in the banking sector, had caused investors to seek safety, driving Treasury bond yields down very close to their lows of 2003, a time when the short-term Federal Funds rate was only 1% and people were worried about deflation - negative inflation.

By late January, the 10-year Treasury bond rate was yielding only 3.28%.

That has certainly changed. In just one month, that 10-year Treasury bond yield rose from 3.28% to 3.90%, giving holders of 10-year T-bonds a capital loss of about 6% of their principal. The yield was 3.85% yesterday.

Clearly, Treasuries are no longer a safe haven.

The U.S. Federal Reserve and the Bush administration would like them to remain in that role.

However, this federal-level duo isn't going about it in the right way. The Fed has cut short-term interest rates from 5.25% to 3% in the last 6 months - that's why commodity prices have suddenly put on a new spurt, with oil soaring from less than $70 a barrel to around $100. That raises the likelihood of inflation. In the short term, lowering short-term rates may lower Treasury bond yields and help the bond market; in the long term, it is likely to have the opposite effect.

As we've seen before, once inflation gets a grip, it is very difficult to shake. At some point, the Fed will have to increase its interest rates and whichever administration is in power will have to cut the federal budget deficit. Since it's unlikely that politicians or the Fed will recognize this unpleasant necessity voluntarily, they will have to be forced into it. The way they get forced is through the Treasury market: prices drop sharply and the regular Treasury bond auctions suddenly find no subscribers, except at the short end.

When that eventuality arises, you don't want to be owning long-term Treasuries. If your investment is only yielding 3%-plus, a capital loss of 6% is substantial - the equivalent of about 2 years' income. If long-term interest rates were to rise to even 5.2% -- a level they touched as recently as 2006 - you would lose another 12% on your money.

You can do a little better by buying Treasury Inflation Protected Securities (TIPS), the principal and interest of which are linked to the Consumer Price Index (CPI). The trouble is, the income on those things is less than 2%. What's more, the CPI has been fiddled with and really isn't an honest measure of inflation [Please tell me that you didn't REALLY believe inflation was still below 4%?].

The U.S. Bureau of Labor Statistics subtracts a "hedonic" factor to take account of improvements in quality in the high-tech sector. However, the BLS calculates that factor by reference to processor speed, pretending that today's computers are 1,000 times better than those of 1998 because the processor speed is 1,000 times as fast. As anyone who has used a computer for the last 10 years knows, they may be twice as useful, or even four times as useful, but not 1,000 times.

So the official CPI vastly understates inflation, meaning that your real return of just under 2% is actually even less than that, when calculated against true inflation. The difference is about 0.8% per annum; you can calculate that by comparing U.S. TIPS with British Index-Linked Gilts, where the price index hasn't been fiddled with: The British bonds yield about 0.8% less.

To profit from increases in Treasury bond yields, you might consider the Rydex Juno Fund (RYJCX), the price of which is inversely linked to T-bond prices [the fund shorts Treasury bond futures]. The fund has had a poor record since its inception in 2001, but should be due to do a lot better now.

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