(Editor’s Note: When we last featured the thoughts of Doug Behnfield, senior vice-president at UBS in Boulder, he had sketched out some back-of-the-napkin numbers that showed why most Baby Boomers were unlikely to realize their retirement dream.  In the think-piece below, Doug argues that Treasury Bonds are now the place to be as deflation takes hold. The essay begins with a reference to an analysis done by his good friend and colleague, famed bear David Rosenberg of Guskin Sheff.) 

In the discussion about the outlook for Treasury Bonds, you have made the point that supply alone has been an inadequate focus for predicting future prices/yields. Cited as examples are the rise in the 30-Year Treasury Bond yield from 4.7% to 6.7% in 1999, even though bond issuance by the Treasury was practically nil; and the decline in Japanese Government Bond yields over the last 20 years, even though deficit spending has been spectacular in Japan and debt/GDP is approaching 200%. The last I saw, the JGB (10-year) was at 1.3%.

The problem with trying to assess either supply or demand in the current market environment is that everything is so confusing here in the early stages of this new secular paradigm of a global credit collapse. There is no way to get it completely right, so as Lacy Hunt has always maintained, it makes much more sense to assess the outlook for inflation as the primary effort in predicting Treasury rates. Simple and elegant.

Awesome Debt Supply

Still, I have some thoughts on supply and demand. Everyone knows that we are facing awesome supply of Treasury debt.  The Congressional Budget Office has told us the deficit will be over $1 trillion a year, each year for as far as the eye can see, not to mention the $1 trillion plus of existing debt that has to roll over each year. Revenue projections are probably way low. Most observers expect a recession/recovery sequence similar to what always occurred when we were experiencing the secular credit expansion. It is easy to fall off the tax rolls in this country. It seems that the only people who pay taxes are those who make over $100,000. So supply is pretty well defined as enormous in most people's minds.

How can we be bullish on bonds in light of those numbers? We can only be bullish if we have a very big view of demand. But demand analysis doesn't offer the hard numbers that supply analysis does. Demand is a state of mind. It is dependent on how attractive the instrument (in this case, Treasury Bonds) is. And the attractiveness of the instrument is dependent on the perception of what is happening fundamentally in the economy and the markets. Bring out the Ouija Board! It has always been said that buying requires a lot more imagination than selling. But before throwing up our hands, and in recognition of the fact that we are required to have an opinion, let's spend a little time enumerating what makes Treasury Bonds attractive. It's a good place to start.

‘Bond as Enemy’

I am going to use the 30-Year Strip as my proxy for Treasury paper, because it is the purest form and the most outrageous iteration of the "bond as enemy". We have said that the 0% coupon Treasury Bond is the benchmark, risk-free asset for funding actuarial liabilities. Read that again. There is no other investment vehicle on the planet that you can buy and know exactly how much money you will have 30 years down the road.

Today I bought August 2039 Principle Strips at 24.75 for a 4.86% yield to maturity. That is about inflation plus 3%. And it is compounded semi-annually at 4.86% so I have no reinvestment or credit risk. But wait, aren't I forgetting about inflation risk? Only to the extent that I am also forgetting about disinflation/deflation reward. Consider this: 29 years ago, inflation was 13.5% and 30 year Treasury bonds yielded 15.25%. Inflation plus 1.75%. If they had 30-Year Strips back then, the buyer would have seen the spread go from inflation plus 1.75% to inflation plus 13% today and we still have a year to go.  But that was then. Today inflation is below 2%. If inflation went back to 5% in the years to come, my purchase today would be chained to a negative real return, perhaps for decades. Then again, if we go to 2% deflation, which seems much more likely, I'll be at inflation plus about 7%.

Thank Reagan, Deng

So, there you go. We're back to predicting inflation. As previously mentioned, CPI inflation hit 13.5% in 1981 and now it is about 2%. What is so interesting is that from1981 until 2007, we experienced disinflation, even though we were in a credit expansion and the credit expansion morphed into a credit bubble. Credit didn’t begin crashing until 2007. Still, inflation continually declined at the CPI level. That was because airfares from Denver to NYC, like New York strip steaks, were flat for the whole period and things like computers dropped in price by 90%. It seems that the huge expansion of debt relative to household income or GDP that occurred primarily impacted stocks, real estate and other investment asset values that really don't show up directly in the CPI. We can attribute the disinflation in the CPI to broad and dramatic improvement in productivity, thanks to Ronald Reagan, Deng Zhou Ping, and technology. Now that we are in a secular credit collapse, CPI won't take the hit that stocks and real estate will. It is unlikely that New York strips steaks will go below $4 per pound or the flight to Newark will drop below $225. But for the next few years, 2% or 3% CPI deflation is not unlikely. Case-Shiller has houses down 36% from the peak and we are seeing similar numbers in commercial real estate. The S&P is down 31% from it's 2007 high after a 65% bear market rally. All of the sudden, current inflation plus 3%, guaranteed and compounded seems attractive.

‘Gambler’s Ruin’

Which leads me back to demand as a function of attractiveness. Retirement income is an important topic these days. Baby Boomers are nearing the end of their working lives and pensions are underfunded. Which brings up the subject of "Gambler's Ruin". The term refers to the normal human response to losing more than you can afford to lose. That response is to bet more aggressively to recover, thereby causing you to fall off the table. PERA, the Colorado State Pension Fund, is woefully underfunded after years of losing money in stocks and real estate, while maintaining an 8.5% return assumption. At some point, doesn't someone tell them to stop gambling, go to the cashier and fix their problem by working with contribution rates and benefit levels? One can imagine demand emanating from household savings accounts that are just looking for a coffee can and banks playing the yield curve. And with the currency markets being such an enigma, it may be premature to rule out ongoing “flight to quality” buyers from abroad.

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-- Posted Tuesday, 9 March 2010 | Digg This Article