Is the Treasury Run Over?

Since the beginning of the year, it’s been a “Tale of Two Cities” for U.S. stocks and long-term U.S. Treasuries. Equity ETFs like the Vanguard Total Stock Market ETF (VTI) have risen swiftly, while the long-term Treasury ETFs like the iShares Barclays 20+ Yr Treasury Bond ETF (TLT) have fallen swiftly.

On the fundamental side, Chinese investors have been cutting their Treasury holdings, and the Federal Reserve’s massive shift from short-term to long-term Treasuries is ending in June. On a technical basis, long-term Treasuries have been trading below key technical levels like their 50-simple day moving average. What lies ahead for long-term U.S. Treasuries?

Since 2008, the Federal Reserve has taken drastic steps to keep interest rates from skyrocketing. The Fed has held benchmark interest rates between zero and 0.25% over the past three years and pledged to keep them there through 2014. In another financial maneuver aimed at jumpstarting the economy, the Fed gobbled up $2.3 trillion in mortgage securities and government bonds. Treasury bonds, particularly long-dated issues with 20-plus years until maturity, reacted by surging. In 2011, the iShares Barclays 20+ Yr Treasury Bond ETF (TLT) gained almost 34% in value.

Europe’s sovereign debt crisis helped to boost long-term Treasury prices too, as global investors favored the perceived safety of U.S. government debt over European rivals.

 “Treasury yields are being repressed by the Fed and by exorbitantly high levels of risk aversion — neither factor is sustainable in the long term,” said James Kostohryz, CEO and global investment strategist at JK Advisory Services in Cartagena, Colombia. For this reason, he warns against owning Treasuries, especially with longer maturities.

The phenomenon of suppressed yields hasn’t stopped income starved investors from snapping up long-term Treasuries. In an effort to squeak out a few extra basis points of yield, they’ve fled money market funds, which carry even more depressed yields. But in an effort to help themselves, these same investors — “yield hogs” as they’re called — likely have purchased their Treasury bonds at the top.

A strengthening economy puts a damper on hopes the Fed will buy more U.S. debt through quantitative easing. It also makes the prospect of future gains in Treasury prices low. “Treasuries do not represent good value on any historical or even forward-looking measure,” added Kostohryz.

Inflation and Credit Risk

Last year the U.S. government lost its pristine credit score when Standard & Poor’s downgraded U.S. sovereign debt from AAA to AA+. Could this be the start of an ugly cycle of declining creditworthiness for Washington D.C.?

While the extent of the downgrade is minor, the implications are major. As the 2011 debt ceiling negotiations underscored, the U.S. cannot run its day-to-day operations without borrowing money. It lives on credit (as do most countries in the world today) and anything that impacts its ability to borrow money has serious consequences.

“We believe that our country is in an admirable position with its strong credit rating, but credit ratings are becoming more about math than perception, and the statement on the U.S. dollar about ‘in God we trust’ is vulnerable,” said Daniel K. Weiskopf III, principal of global ETF atrategies at Forefront Capital in New York. “Our long term concern is that we as a debtor nation are handicapping our future generations.”

History shows that escalating governmental debt can be a significant factor in slower long-term growth and/or higher inflation. In either scenario, Weiskopf believes Treasury investors stand to lose out, and thus he has avoided long-term Treasuries as part of his fixed income strategy.