The Treasury-bubble meme

By Felix Salmon
August 18, 2010
Barry Ritholtz says so explicitly, while Jeremy Siegel and Jeremy Schwartz lay out the, um, logic:

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It’s something of an emerging meme: Treasuries are the new dot-com stocks. Barry Ritholtz says so explicitly, while Jeremy Siegel and Jeremy Schwartz lay out the, um, logic:

Ten years ago we experienced the biggest bubble in U.S. stock market history—the Internet and technology mania that saw high-flying tech stocks selling at an excess of 100 times earnings. The aftermath was predictable: Most of these highfliers declined 80% or more, and the Nasdaq today sells at less than half the peak it reached a decade ago.

A similar bubble is expanding today that may have far more serious consequences for investors. It is in bonds, particularly U.S. Treasury bonds…

The rush into bonds has been so strong that last week the yield on 10-year Treasury Inflation-Protected Securities (TIPS) fell below 1%, where it remains today. This means that this bond, like its tech counterparts a decade ago, is currently selling at more than 100 times its projected payout…

The possibility of substantial capital losses on bonds looms large. If over the next year, 10-year interest rates, which are now 2.8%, rise to 3.15%, bondholders will suffer a capital loss equal to the current yield. If rates rise to 4% as they did last spring, the capital loss will be more than three times the current yield. Is there any doubt that interest rates will rise over the next two decades as the baby boomers retire and the enormous government entitlement programs kick into gear?

I’m sympathetic to the Jeremys’ underlying idea, but this argument is utter nonsense.

For one thing, a drop of 80% in a stock price is not in any way similar to a drop of 3% or even 9% in a bond price. And with Treasury bonds, no matter how much they cost, you’re always guaranteed to get back more money than you paid for them — all you need to do is hold them to maturity.

It’s simply untrue to say that the 10-year TIPS “is currently selling at more than 100 times its projected payout”, and it’s silly and specious to use that number to try to imply that the security looks like some latter-day Juniper Communications.

And note the rhetorical sleight of hand that the Jeremys manage to hide in that final paragraph: they start by talking about capital losses if rates rise sharply over the course of just one year, and then say that they have no doubt that rates will rise “over the next two decades”. (They also fail to explain why retiring baby boomers mean higher interest rates: I see no evidence that countries with “enormous government entitlement programs” have higher rates than those without them.)

Treasury yields are indeed low right now, but that’s largely because the economy is weak. Most bond investors would love nothing more than for the Jeremys to be proved right and for stocks to start rising impressively as the economy recovers — even if that means losing money on their bond investments. But if the economy gets worse, having your money in safe Treasury bonds is going to help you sleep a lot better than having it in risky and volatile stocks.


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This may be a naive question but do traders normally hold such long-term instruments to maturity?

Posted by levinsontodd | Report as abusive

You lose sleep over your stock market investments? Why? The situation isn’t THAT bad for multinationals, and (at least from your picture) you have decades to go before retirement.

Treasuries offer real returns between -1% and +1.5%, which is fine if you have it made but insufficient to support a retirement. Using the 4% rule, you need a $2M accumulation to produce an inflation-matching income of $80k. If you are investing at zero real returns, you’ll need to save $50k/year for 40 years to hit that target.

Posted by TFF | Report as abusive

At a 4% real return, compounded over 20 years, $10,000 would grow to $21,911. At a 1% real return, it grows to just $12,202.

If history is any indication, small-time investors will stay in bonds (with exceedingly low real returns) until the stock market has a solid year-long rally under its belt. They’ll then edge their way back into stocks, finishing the job just in time to get nailed by the next collapse.

Investment flows from one asset class to another are a large part of what drives valuations.

Posted by TFF | Report as abusive

“If history is any indication, small-time investors will stay in bonds (with exceedingly low real returns) until the stock market has a solid year-long rally under its belt.”

I suppose they may–performance-chasers are my friends, and I shouldn’t say mean things about them. I don’t claim to be a master of the universe, but with a healthy bond allocation and regular rebalancing, I sold stocks to buy bonds in 2008, sold bonds to buy stocks in 2009, and sold stocks again to buy bonds this year. You can look in the rear-view mirror and work out better strategies, of course (sell all your stocks in 2000 and put the money in gold), but you can do a heck of a lot worse.

In my view, both debt and equity are vital to a healthy portfolio.

Posted by ckbryant | Report as abusive

You’re sympathetic to the idea, but not the argument?

First, it’s not an argument, it’s a sales pitch for a fund management company. Second, as a pitch, their purpose is to highlight the benefits of stocks and the risks of alternatives–not to construct a financial model for an academic course. Lastly, do you think they are basically right or wrong?

Is 2.6% on 10 year US Treasuries a good investment? Does the price reflect actions of non-economic actors like Central Banks as well as leveraged purchases from TBTF financial institutions or is it a good deal?

Posted by tinbox | Report as abusive

Wrong! Treasury yields are not low now because the economy is bad, they are low because the Fed makes them so as a result of its ‘belief system’. The Fed set them low so that they could bail out the big banks using more of the taxpayers money – ie the vanks borrow low (at 0.0%) and loan out high (at 4% ) and make a profit and pay themselves outrageous ‘bonuses’ on our nickel. And by keeping rates low they keep the economy stagnant and dying just as what happened in Japan. Only when those who lend money get a fair return and those who need to borrow money can get it at a fair rate do the wheels of the economy turn smoothly. This usually happens at a nominal rate of around 4 to 6%. The current scenario is ripping off the ‘lenders’ , many of whom are retirees. Over the past few years the average interest rate on all the national debt has dropped from around 4.5% to 2.0%. The amount held by Americans is araound $5T, which results in a loss (or ‘destimulation’) to the economy of around $125B. Thanks loads Benji…

Posted by Eric93 | Report as abusive

Maybe people should just work instead of looking to live off of “returns”.

Seriously, you know how retarded most of this sounds? 100 years ago most people supported their kids, and when they got old they lived with their children and helped out with their grandkids. Furthermore, you don’t have to go that far back in history for the whole idea of lending money at interest to have been a crime, they called it Usury (spelling?).

Frankly, I think this whole financial based economy and society based off of financial products is complete and total faggotry.

Posted by murfster | Report as abusive

The parallel with the dot com era is not in bad companies, but in rules based systems that force otherwise sensible investors to do foolish things. Risk managers forced benchmarked investors to put 15% of the fund in a single stock like vodafone “to reduce risk” regardless of valuations. In the same vein asset allocators are being told to sell equities and buy bonds to reduce “risk”. In both cases the rules create a forced buyer and the momentum players come in. Throw in leverage and you have a bubble. Over the last 3 years the total return index on 7-10 year treasuries has risen 35%, the capital gain has far outweighted the yield. Sure the forced buyer won’t suddenly become a distressed seller, but the maarginal trader chasing the capital gain will, and we know for sure the macro hedge funds are playing there as well as the banks, all using a lot of leverage because obviously this is a “safe” area! A 10% capital fall on leverage turns into a rout

Posted by MTinker1 | Report as abusive

“And with Treasury bonds, no matter how much they cost, you’re always guaranteed to get back more money than you paid for them — all you need to do is hold them to maturity.”

Wouldn’t you lose money if yields turn negative even if you held to maturity?

Posted by takloo | Report as abusive

What if inflation takes off in the future? Will the federal government be able to afford higher interest rate payments? The only way it would be able to afford higher payments is by printing more money, which would only make things worse. The United States is walking a tricky and possibly dangerous path. Our trade deficit can also not go on forever.

Posted by 123456951 | Report as abusive

If there is a bubble it’s not about yields it’s about prices. But I don’t think there is a bubble – buying treasuries is a psychological thing imho. Money needs to turn inward and take stock of where it is and where it is going, and US bonds are a quiet place to sit and have a think.

Posted by BigBadBank | Report as abusive

This article by Siegel and Schwartz (which I have not read and don’t intend to) will go down as a classic of stupidity along with “Dow 36,000″, published in 2000, and Nassim Taleb’s: “Every Single Human Being Should Short Treasuries”, from February 2010. Honorable mention to Ben Stein for guaranteeing that the U.S. wasn’t in recession in June 2008 when we were, in fact, in a recession (though it yet hadn’t been officially declared). Then of course, we shouldn’t overlook the catch phrases “Goldilocks economy”, “soft landing”, and the various problems that were described as being “contained”. And those “green shoots” are beginning to wither…

Posted by DetroitDan | Report as abusive