Buy US Treasuries to Protect against Deflation

A recurring economic nightmare, for some, is that China will decide to start selling the $1.4 trillion in US debt that it holds, convert back to yuan and send the dollar plunging. That concern came back recently as China started dumping US debt to pay bills back home and attempt to stimulate a slowing economy. However, it turns out that other foreign and U.S. based buyers of treasuries have stepped up and are purchasing treasuries. Why is this? If the Federal Reserve raises interest rates these treasuries will immediately be worth less. But if the economy continues to slow there is a risk of deflation. The move by many to buy U.S. treasuries can be seen as a move to protect against deflation. Bloomberg writes that the U.S. will survive China’s sales of U.S. debt.

A lot of people I talk to are very worried about Chinese holdings of U.S. sovereign debt. The general idea is that if China decided to dump Treasuries, the U.S. economy would go into a tailspin. This is part of the overall narrative cited by Donald Trump and others that the U.S. is “losing” to China.
That was a plausible story. But now that China’s titanic economic boom is coming to an end, we’re finding that the story wasn’t right.

This became clear when China recently began dumping U.S. debt. In past years, China bought a lot of Treasuries in order to keep its currency cheap, so that it could sell lots of stuff at low prices to the U.S. (whether this was a wise economic strategy is a topic of vigorous debate). But as China’s economy has stalled, there has been pressure on its currency. In August, China allowed its currency, the yuan, to depreciate to some degree. But since then it has been intervening in the foreign exchange markets to keep the yuan from weakening too fast.

The fact of the matter is that China’s economy is in trouble and the U.S. currency and U.S. economy are seen as safe havens in times of trouble. And, if deflation occurs, holding long term treasuries that pay a percent or two of interest will seem like a masterstroke as banks charge you one percent to hold your money!

Risk of Deflation

No less of an authority than Lawrence Summers, writing in The Financial Times, makes the case for fiscal stimulus and expansion of debt as prevention for a massive global downturn ending in prolonged deflation.

This raises the specter of a vicious global cycle in which slow growth in industrial countries hurts emerging markets which export capital, thereby slowing western growth further. Industrialized economies that are barely running above stall speed can ill-afford a negative global shock.

We are in a new macroeconomic epoch where the risk of deflation is higher than that of inflation and we cannot rely on the self-restoring features of market economies. The effects of hysteresis – where recessions are not just costly but stunt the growth of future output – appear far stronger than anyone imagined a few years ago.

Western bond markets are sending a strong signal that there is too little, rather than too much, government debt.

And if the global economies do not aggressively expand the money supply what do you do? Why buy treasuries now? You can buy treasuries to hold your assets in the safe haven dollar and you can buy U.S. treasuries to protect against deflation.

Return on Treasuries

Low interest rates have worried many folks in the fixed income market according to The Wall Street Journal in their articles about the Bond-market blues.

The problem now is how long ultra-loose monetary policy has persisted: more and more low-coupon, long-dated debt has been and is being issued. If interest rates are permanently lower, that will change investor behavior.

Some might seek higher returns by taking on more credit risk; others might choose to buy longer-maturity bonds; still others might seek to leverage low-yielding bonds. But those exhibit bigger price swings, and that creates new risks.

But, those who choose to buy U.S. treasuries to protect against in deflation know that long term investors typically try first of all to beat the rate of inflation and then seek a profit. When one percent of deflation all one needs is a 2% treasury to bet the rate by three percent!

Buy US Treasuries to Protect against Deflation PPT

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