There has been a lot of recent discussion over whether or not there is a bubble in U.S. treasury bonds, and to be honest with you there are some very compelling arguments for both sides. But before we get into some of these arguments I’d like to take a moment to review the significance of the U.S. treasury bonds market.

If you ever wondered how countries are able to finance their spending while accumulating debt, the answer is that it would be through government bonds, which in our case are called U.S. treasuries. Treasuries are the debt financing instruments of the United States Federal government; they allow investors the way to sink their cash into our country, offering a yield on their investment while financing our debt; essentially a loan. These investments are regarded by many to be one of the safest on the planet; however, there are some risks to investing in government bonds. If a country continually racks up too much debt and simultaneously takes a severe hit in their ability to generate tax revenues to repay that debt, then it is quite possible that investors would begin to slack off from buying their bonds, or worse yet, sell them. Remember, the higher the demand for bonds, the lower the yields or interest rates, while the lower the demand, the higher the yields and interest rates. Higher interest rates can cause great difficulty for these countries to repay their debt, so this development in many cases is a very unwelcome one.

Unfortunately, the preceding is what we saw in Greece and Spain this year. These countries have been accumulating tremendous debt through their reckless spending binges, and when the world went through a colossal down turn, their ability to repay their debts was severely diminished. It was at this time that bond holders began to rethink whether or not it was a wise idea to keep holding on to their debt. What ensued was a mass exodus of Greek and Spanish bonds, interest rates went through the roof making it almost impossible to repay their debt, and all of a sudden within just a few weeks there were fears of default, which basically meant that they wouldn’t be able to meet their debt obligations. This sort of turn of events would have a humongous rippling effect. Greece and Spain have very small economies relative to the U.S., but the danger lies in the possible collateral damage. What most people don’t realize is that many large banks are financing these countries debts, therefore if a country were to default on their bond obligations, the banks and investors that bought these bonds would end up with a huge loss. If these banks take a huge loss then their confidence to lend would diminish, banks could freeze up again not lending even to one another, and we could again be stuck with another round of systemic risk similar to what we saw in 2008 where investors sold out of their investment holdings driving down the prices of virtually every single asset class on the planet.

These turnings of events actually caused a positive unintended consequence for the U.S., as many of the banks, governments, and investors which were buying these Greek and Spanish bonds looked to invest their holdings elsewhere, and by default U.S. treasury bonds became a prime destination. So consequently as a result, demand for our debt went higher and yields went lower, allowing our country to borrow more money at a lesser interest rate.

This is not the only driving force or source of demand for our U.S. treasury bonds. An area that is causing tremendous anxiety is our economy where there are fears of a double-dip recession or worse yet, a Japanese style loss of 2 decades. With these sorts of fears, they are causing many investors to move into U.S. treasuries and precious metals as opposed to other riskier assets such as stocks. The lower that interest rates move on our debt, the more the bond market is signaling to the world that we are in for a very slow growth period for a protracted period of time.

So the question that everyone is asking, is there a bubble in U.S. treasury bonds? If you look at the sort of buying that is occurring and the amount of inflows that have gone into U.S. treasuries, it would indicate a bubble. However, there are many supporting arguments that would indicate that a bubble doesn’t exist in the U.S. treasury bond markets.

1. Risky Southern European countries debt load is causing a rush into U.S. treasury bonds.

2. Slow U.S. economy is causing many investors to flee into U.S. bonds rather than stocks, indicating a very slow economy for the foreseeable future.

3. Fears of deflation and the absence of inflation (according to the Fed’s gauges) support lower U.S. treasury yields.

4. Savings rates are rising because people want to rebuild their finances following large losses on their homes and stocks. This means money will continue to funnel its way into investments deemed relatively safe such as U.S. treasuries and precious metals.

5. Bonds (and precious metals) are considered by many investors a good hedge and insurance against equity losses. In this sort of environment, it makes a lot of sense to try to protect your investment portfolio.

6. The elephant in the room is the Federal Reserve. The Federal Reserve is printing money and buying U.S. treasuries. This action from the Federal Reserve pumps more printed money into the economy and artificially keeps rates lower in order to attempt to revitalize our flailing economy (which won’t be good for the value of the U.S. dollar in the medium to long-term).

On the other hand, when you look at our U.S. debt position, it would appear to be contradictory to sound logic that investors would want to pile into U.S. treasuries considering how much debt our country is accumulating. If investors began to reconsider owning U.S. treasury bonds just as they did with Greece and Spain, then we’d highly likely see a cascading effect on our economy; interest rates would soar, the possibility of default on U.S. debt would rise dramatically, banks would freeze, investor sentiment would be next to zero, the economy would go back into a recession and possibly a depression, and the dollar would almost certainly plummet.

I would say that there are very powerful forces which are turning the U.S. bond market that would indicate that there isn’t a bubble in U.S. treasuries. Having said that, the risks of default are tremendous and the markets can suddenly change without a clear warning to many seasoned investors. In my view, the warning IS clear, and personally I don’t believe U.S. treasuries offer as much safety over the medium to long-term as what most people would believe. The risk vs. reward ratio in my opinion doesn’t warrant the demand it has been receiving. A great friend of mine once said that bubbles can grow very large for a very long time before they burst. I wouldn’t be surprised if this trend in U.S. treasury bonds continues for quite some time, but if it does begin to show cracks in its armor, which I believe it will, one of two things will occur, either we will default on our U.S. treasury bonds, or even more likely the Federal Reserve will have to switch gears on the printing presses from full throttle to hyper warp speed, which effectively will diminish the value of the U.S. dollar.

Remember folks, as the value of paper currencies become devalued, the value of alternate currencies such as precious metals becomes worth more.

Matthew Goldfuss

www.gold-observer.com