Why Bet on Treasury Securities?

First Warren Buffet and now Bill Gross, of Pacific Investment Management Company, have publically stated that buying United States Treasury securities is not a good bet. (See http://www.bloomberg.com/news/2011-03-31/gross-echoes-buffett-saying-treasuries-have-little-value-on-debt-dollar.html.)

Gross wrote, in his most recent monthly investment outlook, that Treasuries “have very little value.”

One could couch this in other terms: “What is the probability that long term interest rates will go up over the next twelve months?”; and “What is the probability that long term interest rates will go down over the next twelve months?”.

How many people do you know that believe that the higher probability can be applied to the second of these two questions?

Most people I know and respect are arguing over whether the probability that long term interest rates will go up is 75% or 80% or higher.

The only significant argument I hear about falling interest rates on long term Treasury issues is that the Eurozone might collapse and there will be a “run to quality”, a run to United States government securities. Almost all other arguments go the other way.

The economic recovery, however weak, is continuing. The banking system (and the housing industry) is not going to collapse even though the banking industry is going to continue to grow smaller and smaller in terms of the number of commercial banks that are in the system while the biggest banks, including large foreign banks, are going to control more and more of the banking industry itself. The Federal Reserve will continue to keep money flowing into the banking industry so as to keep banks open while the FDIC makes sure that the banking industry shrinks in an orderly fashion.

Are we going to get QE3? Depends upon the rate at which insolvent banks can be closed without disrupting the financial system. The strength of the economic recovery is not the issue. The issue, to me, depends upon what the FDIC can achieve.

The federal government is going to continue to add more and more debt to the total already outstanding.

There just is no credibility in Washington, D. C. concerning the reduction in the cumulative deficits over the next ten years or so. I still believe that the government will add another $15 trillion or more to the federal debt outstanding over the next ten years.

The Libyan situation is a case in point. The federal government is so over-extended fiscally that other demands on its resources are just going to stretch budgets even further and keep the cumulative deficits at near-record levels. Then the government ends up doing two things, neither desirable: the government is limited in what it can do in very important situations; and even if the government cannot do much, whatever it does will increase the cumulative deficit.

Then there are other issues, like the boom in commodity prices worldwide, the acceleration of the merger and acquisition business in America, Europe, and the emerging countries, and currency speculation throughout the globe.

As a consequence, I see no reason to back off my earlier thoughts on the future of the interest rate on long term U. S. Government securities. See http://seekingalpha.com/article/250838-long-term-treasury-yields-and-inflationary-expectations. This post was written when the yield on the 10-year Treasury security was 3.48 percent, roughly two months ago at the beginning of February. Yesterday the 10-year Treasury closed at about 3.46 percent.

At that time I claimed that a forecast of 5.00 percent to 5.50 percent was not out of reason for a Treasury security of this maturity somewhere in the next 12 to 18 months.

The basic reasoning for this: my estimate of the expected long run “real” rate of interest is roughly 3.00 percent, (Similar, I found out, to the belief of the Wharton School’s Jeremy Siegel.)

I further believe that investors will come to build in a premium for inflationary expectations in longer term interest rates in the neighborhood of 2.00 percent to 2.50 percent.

How strongly do I feel about this prediction? I believe that the odds are in the neighborhood of 3- or 4-to one that rates will move into this range over the next 12 to 18 months.

Thus, I would have to agree with Bill Gross (and Warren Buffet) that Treasuries “have very little value” and are not a good “buy and hold” at this time.