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Across all tradeable markets and currencies, U.S. Treasuries — government bonds — have significant influence. In finance, any risk measurement is relative, meaning, if one insures a house, the maximum liability is set in some form of money.
Similarly, if a loan is taken from a bank, the creditor has to calculate the odds of the money not being returned and the risk of the amount being devalued by inflation.
In a worst-case scenario, let’s imagine what would happen to the costs associated with issuing debt if the U.S. government temporarily suspended payments to specific regions or countries. Currently, there is over $7.6 trillion worth of bonds held by foreign entities and multiple banks and governments depend on this cash flow.
The potential cascading effect from countries and financial institutions would immediately impact their ability to settle imports and exports, leading to further carnage in the lending markets because every participant will rush to reduce risk exposure.
There are over $24 trillion in U.S. Treasuries held by the general public, so participants generally assume that the lowest risk in existence is a government-backed debt title.
Treasury yield is nominal, so mind the inflation
The yield that is widely covered by the media is not what professional investors trade, because each bond has its own price. However, based on the contract maturity, traders can calculate the equivalent annualized yield, making it easier for the general public to understand the benefit of holding bonds. For example, buying the U.S. 10-year Treasury at 90 entices the owner with an equivalent 4% yield until the contract matures.
If the investor thinks that the inflation will not be contained anytime soon, the tendency is for those participants to demand a higher yield when trading the 10-year bond. On the other hand, if other governments are running the risk of becoming insolvent or hyperinflating their currencies, odds are those investors will seek shelter in U.S. Treasuries.
A delicate balance allows the U.S. government bonds to trade lower than competing assets and even run below the expected inflation. Although inconceivable a few years ago, negative yields became quite common after central banks slashed interest rates to zero to boost their economies in 2020 and 2021.
Investors are paying for the privilege of having the security of government-backed bonds instead of facing the risk from bank deposits. As crazy as it might sound, over $2.5 trillion worth of negative-yield bonds still exist, which does not consider the inflation impact.
Regular bonds are pricing higher inflation
To understand how disconnected from reality the U.S. government bond has become, one needs to realize that the 3-year note’s yield stands at 4.38%. Meanwhile, consumer inflation is running at 8.3%, so either investors think the Federal Reserve will successfully ease the metric, or they are willing to lose purchasing power in exchange for the lowest risk asset in the world.
In modern history, the U.S. has never defaulted on its debt. In simple terms, the debt ceiling is a self-imposed limit. Thus, the Congress decides how much debt the federal government can issue.
As a comparison, an HSBC Holdings bond maturing in August 2025 is trading at a 5.90% yield. Essentially, one should not interpret the U.S. Treasury yields as a reliable indicator for inflation expectation. Moreover, the fact that it reached the highest level since 2008 holds less significance because data shows investors are willing to sacrifice earnings for the security of owning the lowest risk asset.
Consequently, the U.S. Treasury yields are a great instrument to measure against other countries and corporate debt, but not in absolute terms. Those government bonds will reflect inflation expectations, but could also be severely capped if the generalized risk on other issuers increases.
The views and opinions expressed here are solely those of the author and do not necessarily reflect the views of Cointelegraph.com. Every investment and trading move involves risk, you should conduct your own research when making a decision.
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By: Cointelegraph By Marcel Pechman
cointelegraph.com