The treasury paradox

Government bonds were at the heart of the debt ceiling drama.

For decades, they were seen as the ultimate safe asset – the foundation of the global financial system. But as the deadline approached for an agreement to avert a US debt burden, Treasury bills due in early June were priced as nearly the equivalent of junk bonds.

In the market for credit default swaps, government bonds were suddenly considered riskier than the government debt of countries such as Mexico, Bulgaria and Greece.

But in the nick of time, President Biden and Chairman Kevin McCarthy reached an agreement to suspend the debt ceiling. The Senate on Thursday gave final approval to legislation to ensure that the treasury does not run out of money.

So the United States has averted formal bankruptcy, after another wild, nerve-racking ride. What should wary investors take away from this disaster close call?

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

That has been the tried and true solution for investment agita in the past. And it will probably – though not certainly – be the solid answer to some fundamental investment problems now and for the foreseeable future.

The Enduring Attraction of Treasury Bills

Numerous crises in the United States and abroad have seen investors flock to the $24 trillion Treasury market just about whenever they needed a refuge.

For starters, it’s the deepest market in the world. Even with the sanctions and tariffs and money laundering controls imposed by the United States over the past few decades, the U.S. Treasury market remains quite open and easily accessible by international standards. If you want to buy and sell securities quickly, painlessly and at a low cost, government bonds and the US dollar have been very good bets. No other global asset class offers the same benefits.

The most important feature of Treasuries is the one that was so obviously vulnerable during the debt crisis: security and stability. Treasury bonds have often been a balm. If all else seemed unsafe, you could count on getting your money back if you put it in a government bond and held it to maturity.

Even now, the “full faith and credit of the United States” has never been violated. It is guaranteed by the Constitutionby the country’s long history as a stable country governed by law and by the combination of economic, military, and political power that has made the United States unique.

The big caveat

If you can rely on anything on this planet since World War II, it’s the United States’ ability to pay its bills.

But every time the United States faced a debt-ceiling stalemate, that assumption seemed naive. It has never been a question of whether the country has sufficient resources. What is in doubt is whether the political system would function well enough for the US government to raise enough money to continue operating.

Whenever debt negotiations broke down, they were resolved without default—and eventually the Treasury market bounced back.

Such rallies are typically what happens when world crises upset the volatile stock market and investors seek refuge. Taking refuge in Treasuries makes sense when the crisis is abroad – as was the case in the early stages of the crisis BrexitFor example.

Putting money into Treasuries when the crisis comes from the United States may be counterintuitive, but it’s been done many times before. It’s “Ghostbusters” logic: where else do you go?

In 2011, for example, a protracted debt limit dispute nearly ended in bankruptcy and led to Standard & Poor’s downgrading the original AAA rating of US debt. Nevertheless, Treasuries recovered, even though they were the cause of the problems in the financial markets.

Now that the threat of default has passed, Treasuries are likely to resume their role as a haven in a storm this time around.

This may have the air of inevitability, but it was not certain.

The cracks that emerged in May in the Treasury and credit default swap markets were real, and many contingency financial plans contained a small probability of a major event: a US default. There could be further downgrades of US debt as the country’s politics become increasingly unmanageable and dysfunctional, and skepticism about the soundness of Treasuries could further diminish their luster. Financial services firms such as Goldman Sachs and MSCI included government bond bear markets in their low-probability, high-risk scenarios for the latest crisis.

The Bond prospects

For now, however, the outlook for the Treasury market looks quite rosy. Recall that on May 24, yields on Treasury bills due early June shot above 7 percent, a sign that traders were demanding a hefty risk premium to buy them. Those revenues fell below 6 percent after Memorial Day, according to data from FactSet. Prices, which are moving in the opposite direction to yields, soared. And in the credit default market, the price of Treasury underwriting has fallen to about one-seventh of its peak during this latest crisis.

Besides the debt ceiling, other factors dominate the bond market. The main ones are the Federal Reserve’s long struggle to control inflation through tightening monetary policy, the possibility of a recession and the pressure on regional banks from rising interest rates.

Will the Fed hike short-term rates at its next meeting in June? Traders are now bet that it won’t happen. In addition, many indicators indicate that a recession is imminent.

Those factors make the case for bonds – both high quality corporate bonds and government bonds – quite compelling. Bond yields have already risen sharply over the past year and those yields are a reasonably good predictor of bond market returns. Remember, if you hold Treasury bills for an entire year, you can count on a return of more than 5 percent, which is a high threshold for riskier investments. Compared to equities, short-dated government bonds are attractive.

The case is slightly less strong for longer-term bonds, as their yields are lower. In bond market jargon, the yield curve is inverted. That suggests traders are expecting a recession, in which the Fed would be forced to cut short-term interest rates to stimulate the economy.

Recessions are typically bad for most people — and for the stock market — but they’re usually great for government bonds, because investors will seek their old reserve-safe assets, and as market yields fall, Treasury prices rise.

In short, the past few weeks have threatened Treasuries. The risks of holding these supposedly risk-free assets have become all too apparent of late. But with any luck, government bonds will likely emerge from a debt crisis as they essentially always have been. In a world where nothing is completely safe, treasury bills remain a relatively safe place to park your money.