The Treasury paradox

TREASURY bonds have been at the heart of the debt-ceiling drama.

For decades, they have been viewed as the ultimate safe asset – the bedrock of the global financial system. But as the deadline for an agreement to avert a US debt default loomed, Treasury bills due in early June were priced as the near equivalent of junk bonds.

In the credit default swaps market, Treasury bonds were suddenly deemed riskier than the sovereign debt of countries such as Mexico, Bulgaria and Greece.

US President Joe Biden and Speaker Kevin McCarthy reached a deal to raise the debt ceiling – and set federal spending limits – but it was left to Congress to enact legislation before the United States ran out of money, which could have happened this week.

With that deadline-beating deal, the US averted a formal default, but it has been another wild, unnerving ride. What should wary investors take away from this close call with disaster?

Paradoxically, the best answer may be exactly what it was before this crisis – for safety, buy Treasuries.

That has been the time-tested solution to investment agita in the past. And it is probably – though not certainly – going to be the solid answer to some basic investing problems now and for the foreseeable future, too.

The enduring appeal of Treasuries

Through countless crises in the US and abroad, investors have flocked to the US$24 trillion Treasury market just about whenever they have needed a haven.

For one thing, it is the deepest market in the world. Even with the sanctions and tariffs and money-laundering controls imposed by the US in the past few decades, the US Treasury market remains quite open and easily accessible, by international standards.

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If you want to buy and sell securities quickly and painlessly and at low cost, Treasuries – and the US dollar – have been very good bets. No other global asset class offers the same advantages.

The most important feature of Treasuries is the one that was so evidently vulnerable during the debt stand-off – safety and stability. Treasury bonds have often been a balm. When everything else seemed unsafe, you could count on getting your money back if you stashed it in a Treasury bond and held it to maturity.

Even now, the “full faith and credit of the United States” has never been breached. It has been guaranteed by the Constitution; by the nation’s long history as a stable country ruled by law; and by the combination of economic, military and political power that has made the US unique.

The great caveat

If you could rely on anything on this planet since World War II, it has been the ability of the US to pay its bills.

But each time the country has faced a debt ceiling stand-off, that assumption has seemed naive. It has never been a question of having sufficient resources.

What has been in doubt is whether the political system would function well enough for the US government to raise enough money to keep operating.

Whenever the debt negotiations have gone down to the wire, they have been resolved without a default, and the Treasury market has ultimately rallied.

Such rallies are typically what happens when world crises upset the fickle stock market and investors seek somewhere safe. Finding refuge in Treasuries makes sense when the crisis is overseas, as was the case in the early stages of Brexit, for example.

Putting money into Treasuries when the crisis emanates from the US may be counterintuitive, but it has happened many times. It is Ghostbusters logic: Where else are you going to go?

Back in 2011, for example, a protracted dispute over the debt limit nearly ended in a default and led to a downgrade in the pristine “AAA” rating of US debt by Standard & Poor’s. Nonetheless, Treasuries rallied, even though they were the source of the trouble in financial markets.

This time around, now that the threat of default is behind us, Treasuries are likely to resume their role as a haven in a storm.

This may have the air of inevitability, but it has not been a sure thing.

The fissures that became visible in the Treasury bill and credit default swaps market in May were real, and many financial contingency plans included a small probability of a dire event – a US default.

Further downgrades of US debt could be coming if the country’s politics become increasingly fractious and dysfunctional, and scepticism about the solidity of Treasuries could still dim their lustre.

Financial services companies such as Goldman Sachs and MSCI included bear markets for Treasuries in their low-probability, high-risk scenarios for the latest crisis.

The bond outlook

For now, the prospects for the Treasury market look rather bright.

Recall that on May 24, the yield on Treasury bills with early June maturation dates shot above 7 per cent, a sign that traders demanded a hefty risk premium for buying them.

Those yields dropped to the 5 per cent range after Memorial Day, indicated data from FactSet. Prices, which move in the opposite direction of yields, soared. And in the credit default market, the price for insuring Treasury debt has fallen to roughly one-third of its peak during this latest crisis.

Beyond the debt ceiling, other factors dominate the bond market. Foremost are the Federal Reserve’s long struggle to bring inflation under control by tightening monetary policy, the possibility of a recession and the pressure on regional banks resulting from rising interest rates.

Will the Fed raise short-term rates at its next meeting, in mid-June? Traders are now betting that it will not. In addition, many indicators suggest that a recession is on the way.

Those factors make the argument for bonds – high-quality corporates as well Treasuries – quite compelling. Bond yields have already risen sharply over the last year, and those yields are a reasonably good predictor of bond market returns.

Consider that if you hold a one-year Treasury bill for a full year, you can count on a return of more than 5 per cent, which is a high threshold for riskier investments. Compared with stocks, short-term Treasuries are attractive.

The case is a bit weaker for longer-term bonds because their yields are a lower. In bond-market jargon, the yield curve is inverted. That suggests that traders are expecting a recession, in which the Fed would be compelled to lower short-term interest rates to stimulate the economy.

Recessions are typically bad for most people – and for the stock market – but they tend to be great for Treasury bonds, because investors will seek their old standby, and as market yields fall, Treasury prices rise.

In short, the past several weeks have threatened Treasuries. The risks of holding these supposedly risk-free assets have been all too evident lately.

Yet with a little luck, Treasuries are again likely to emerge from a debt crisis as essentially what they have always been.

In a world where nothing is entirely safe, Treasuries remain a relatively safe place to park your money.