Is a bubble in treasury debt market forming? If so, how long could it still go on? How might it burst? What would be the consequences and the collateral damage of its bursting?
The recent rapid expansion in money supply is barely reaching consumers and small businesses in the form of loans, to a great extent due to structural damage suffered by the institutions and credit intermediaries which act as conduit for the flow of funds in the economy. As such, quantitative easing is having limited success in stimulating demand, but the excess supply is creating a bubble in the treasury debt market. The 30-yr. treasury yield closed at 3.04% on Friday, Dec. 12th, 2008.

Have an honest look at the fed's balance-sheet, US budget deficit, record public debt which is still expected to dramatically and indefinitely grow, the exploding liabilities of the entitlement programs, the slowing US economy and the increasingly Japanese style of bailouts of failing private enterprises with public funds. Does it make economic sense to lend money to the US for 20+ years for a paltry 3% return?

Greetings Arsalan,

(a) Is there a bubble forming in Treasuries?
Very likely... it will burst when the Banks open their end of the spigots again.

(b) If so, how long could it still go on?
Almost impractical to put a hard timeline on this... many risk events yet to play out, even though Ben Bernanke and compatriots are trying to flood the market with liquidity; "trying" being the operative word here. Remember, the likes of Merrill Lynch are still advocating that Treasuries will outperform other markets in 2009... which is quite difficult to believe.

Recent demand for Treasuries has been rather buoyant based on bid-to-cover ratios, seemingly due to large Corporates and institutional holders not having faith in even the major banks to hold their temporary client funds or other short term capital.

(b) How might it burst?
Quite simply, return of risk appetite and release of liquidity by the major banks to end economic agents, i.e. you and me, corporates, etc.

(c) Consequences?
The US dollar could take a major toll among other things. The Greenback's fall over the last five years took a breather in the past six months, but we may see that downward trend resuming in the foreseeable future.

If there is not enough demand for US sovereign debt, what's going to happen to the funding shortfall? Recent TIC (Term Inflows) statistics show that the US was having a hard time attracting capital.

Remember, if major risk events continue to happen, such as sovereign default in key countries, or requirement to further recapitalise banks globally, it may help keep a temporary floor in the Greenback's value.

Lending to Uncle Sam for a measly 2% a year does not make economic sense, but neither does it make sense to loose 15% to 20% of your capital by committing to equity or corporate debt markets. Investors are not relying on Corporate Debt because of high risk of default and loss of earning power which could have significant impact on interest and principal payments.

Another thing is that a lot of banks outside the United States have Dollar denominated liabilities for which they required adequate collateral, hence the swap lines being established by Federal Reserve with various countries.

It's merely a safety play which will unwind at some point in the foreseable future bar any major black swan events (default of certain G8 economy, etc).

Lets not even get started on the unfunded public liabilities, fiscally irresponsible lending windows, bailout programmes, etc !

Hope that helps.

Arsalan,

Here is another article from Bloomberg, which discusses that Treasuries are not in a bubble because there is more room in the Long Bond for falling yields:

Bloomberg Link

I don't totally deny that there is some room left in the long end of the curve but when investors flee various parts of the curve, it's going to be like a springboard effect !

Trade frictions between Beijing and Washington are expected to grow amid a deepening world recession and as U.S. interest groups demand President-elect Barack Obama put "tough on China" trade talk into action.

The U.S. Trade Representative's office on Friday announced it had begun legal action at the World Trade Organization (WTO) aimed at halting Chinese government subsidy programs to boost the sale of Chinese-branded goods around the world.

The action, against a patchwork of cash grants, preferential loans and other incentives paid to Chinese exporters, follows recent U.S. moves to put import duties on Chinese goods, including steel products, paper and off-road tires.

China, where millions of workers have been laid off in recent months amid slowing exports, has protested against the charge, casting incentives given by local governments to exporters as merely one-off, symbolic "rewards."

Just about everybody got wrong-footed by 2008, but some people's mistakes were truly spectacular

Here are some of the worst predictions that were made about 2008. Savor them—a crop like this doesn't come along every year.

1. "A very powerful and durable rally is in the works. But it may need another couple of days to lift off. Hold the fort and keep the faith!" —Richard Band, editor, Profitable Investing Letter, Mar. 27, 2008

Obama has been working with his advisers so that the proposed $750-billion-and-counting package of tax breaks and spending on infrastructure, education, health care and unemployment insurance is ready to go on Day One. (No on-the-job training necessary!)

There are currently about 10 million unemployed workers in the U.S. (The Bureau of Labor Statistics defines as unemployed those persons who didn’t work in the week of the monthly employment survey, were available for work and made an effort to find work in the previous month.)

“If we write a check for $75,000 to each of the unemployed, we won’t have anyone ‘unemployed,’” said former Treasury Secretary Paul O’Neill.

The recipients may not be working in the traditional sense of going to the office each day, but the government can provide for their needs without anyone having to lift a finger.

The Obama administration’s goal of creating 3 million new jobs by January 2011 will run smack into “the natural demographic flow, which will add 3.2 million people to the workforce” in the same time period, O’Neill said. In effect, “we are going to spend $750 billion, the number of unemployed will rise and the (unemployment) rate will go down slightly.”

Shoveling to Prosperity

O’Neill did the math so you don’t have to. Each job “will cost $250,000, which doesn’t suggest much labor intensity for the dollars spent,” he said. “It makes me wonder if any of the planners or commentators are good at arithmetic.”

They’re not good at arithmetic. And one wonders about their facility with economics.

If putting people to work is the goal, we could get rid of all the heavy earth-moving equipment and go back to digging ditches with shovels.

Why stop there? If it takes one man two days to dig a trench three feet deep and 30 feet long with a shovel, how long would it take 100 men using spoons?

You get the point. We can always create jobs by replacing capital with labor, by going backward. The entire history of civilization has been characterized by an effort to move in the opposite direction and become more productive, which is another way of saying produce more with less.

Automation and technological innovation have had the effect of replacing humans with machines. Yet the unemployment rate isn’t perpetually rising. As countries develop, they create new and better jobs, not more of the same old ones. The goal is to raise the standard of living, something that (all economists agree) can only be achieved through higher productivity growth.

He says he's a lousy market timer, but there are great opportunities in commodities and recommends that people look at ETFs and ETMs. Says oil will eventually go way high again.

Still liquidating his remaining dollar positions.

....
However, this is something you will have to figure out on your own as there will be no Trader's Corner 2009. Thanks to everyone that contributed. I appreciated your insights and thank you for allowing me to think aloud on these pages. It has been a great help to me personally and professionally. Now it is time to move on. Take care and all the best in the new year. Cheers. MrBill.

As for predictions I expect more bad news from the real economy in Q1'09, and probably all of 2009 will be a write-off as far as global growth is concerned. I am expecting an L-shaped recovery at best, although I am sure unemployment and store bankruptcies will no doubt spike after the last Boxing Day sale takes place. Volatility will remain high regardless, so on a risk adjusted basis returns will remain under pressure. I believe energy and commodities are now over-sold, and that selectively one can re-enter some sectors, but cautiously. This is a beggars' banquet and not a moveable feast.