Market Impact: 2009 Watch List – Part 10

When the US treasury bubble bursts….

What will dominate?

The good news: “…When the Treasury bubble does pop, it will likely be a sign that the economy is turning around and that credit is more available again, experts said. People will sell off their Treasury holdings because they think that stocks and corporate bonds will offer better returns….”

The Bad News: “... investors could lose money even on super-safe Treasuries. A swift increase in yields would send prices plummeting. For every 1 percentage point increase in yield on a 10-year note, investors would see a corresponding 7 percentage point drop in value…This would leave investors in a tough bind - either hold onto a note with yields that could be far lower than the market rates at the time or sell it at a steep loss.”

As Economist notes

“The dilemma is just as acute for government-bond investors. The example of Japan shows that bond yields can stay low for a long time. Ten-year yields of 1-2% could well be possible. But if Japan is not the template, then those yields will look ridiculous; we are heading for a world in which fiscal deficits are exploding and governments seem to be competing to depreciate their currencies. If 2009 does see an equity-market rally, it is likely to be accompanied by a government-bond-market slump.”

There are observers who feel this is not a bubble yet and that Fed will sustain this rally. Bubbles don’t happen when many call it so - the sign would be when a number of new treasury funds are floated.

As the rescue progresses the cost of government borrowing will increase (every one agrees that such huge amounts cannot be borrowed overnight) and that it may crowd out other borrowers is a real risk. It will also increase the interest cost for businesses which might also find liquidity tight once again. If the government limits the cost of borrowing than it puts a lid on how much stimulus and other packages can do.

Monitor how this tradeoff progresses.


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