From the March 2009 issue of Wealth Manager Web • Subscribe!

The Curious Case of Falling Bond Yields

The bear case for the dollar and 30-year government bonds is pretty easy to make: As deficits grow, and the U.S. continues to borrow heavily to finance increased government spending, China and other big buyers of our debt will lose confidence. With demand lessening and the country's debt obligations ballooning, government bonds will dramatically lose value. At the same time, lower rates will pummel the dollar.

As a contrarian, I find this nearly unanimous view a tempting target. While I admit to having sung in that chorus, its undisputed popularity has convinced me to revisit my view. In fact, writing a happy ending for these two assets may be easier than it appears.

First, consider the supply side of the equation. Although government borrowing is certainly heading higher in this New Deal environment, debt as a percentage of GDP is still less than 50%. That's below the levels seen during the last recession, and quite a bit less than the GDP of many other developed countries--including France (80%), Great Britain (80%) and China (80%). If the long end of the Treasury curve did come under pressure, the Fed could always buy back 30-year debt in favor of short-dated securities, as the rates on the latter are much cheaper.

The Fed all but said that was their plan last October. At the time it seemed a bit odd that the government saw a need to support longer maturities, but it certainly makes a lot more sense now.

What about demand? Consider the supply of U.S. currency, which presently stands at around $900 billion in circulation. With a current population of 300 million people, that comes to about $3,000 for every man, woman and child in America.

However, there are not a lot of folks with that much money in their wallets. Even when factoring in cash registers, banks and other corporate holders of cash, there are a lot of greenbacks washing around the system.

As it turns out, most of that is held by foreigners--Bulgarian taxi drivers, Argentinean waiters, and other service providers who are much more comfortable holding the U.S. dollar than their home currency. Since all currencies are valued relative to their worth in other currencies, our relatively stable domestic economy will more than likely put a floor on the value of the dollar.

The logic supporting the dollar and Treasury bonds won't last forever. As the global economy recovers from the current morass, investors will abandon what is familiar in search of more risk. In the meantime, I expect these two investments to hang in there.

Ben Warwick is chief investment officer of Quantitative Equity Strategies, LLC, in Denver, Colo. and Memphis-based Sovereign Wealth Management, Inc.

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