The Case for Higher Treasury Yields... And Lower REIT Prices

The prospect of rising Treasury yields will pressure REIT valuations. “Yield instruments” like REITs are priced to yield a “spread” over Treasuries. So prices of yield instruments usually fall when Treasury yields rise. I am anticipating this exact scenario.

I’m a bear on Treasury bonds. Prices should go down and yields should go up as the creditworthiness of the US government deteriorates. Right now, with the 10-year yield at 3.64%, investors are assuming that the future direction of inflation and budget deficits will remain under control. Treasury bond bulls will argue the following points about inflation, federal deficits, and the existing stock of Treasuries. I’ve listed the bullish consensus view in bold type. My responses, listed as the alternative view, will follow each consensus view:

Consensus view on inflation: “High unemployment and low manufacturing capacity utilization will keep inflation fears in check. So those folks expecting inflation fears to push Treasury yields higher in 2010 are a few years early.”

Alternative view: Outside of the panic liquidation conditions of fall 2008 or the Great Depression, rising prices are hard-wired into the US economy. If investors panic once again and desperately seek to hold cash, the Fed can team up with spending addicts in Congress to create new US dollars in limitless quantities. The past two years have proven this out.

The issue isn’t whether the government can satisfy demands of investors looking to liquidate assets and hold dollars. As long as Treasury yields remain low, the government can create limitless amounts of new credit to satisfy investor demand for default-free government liabilities (Treasuries and paper money).

Instead, the real risk facing financial markets over the next few years is whether investors will remain willing to hold cash and Treasuries at low yields. Cash has no intrinsic value beyond the belief that it can be exchanged for goods and services. The value of Treasury securities depends on investors’ willingness to hold them, despite the near certainty that trillions in new Treasury securities will flood the market over the next decade.

The high unemployment/low capacity utilization argument is theoretical, antiquated, and based on a fairly closed, manufacturing-oriented economy. In this theoretical economy, unemployed workers continually bid the price of their labor lower until supply and demand for labor reach equilibrium at lower prices.

Today’s US labor market does not work that way. The work force is very specialized. A laid-off automotive engineer is not likely to underbid the salary of nursing graduates for an open nursing position. Instead, those who have left the labor pool are collecting unemployment benefits without contributing to the aggregate supply of goods and services. When the claims on goods and services grow faster than actual supply, prices rise. The conditions for hyperinflation arise when an economy’s productivity collapses and supply of government liabilities overwhelms demand (as confidence in the value of those paper government notes collapses).

The Federal Reserve promotes the “low capacity utilization” case for low inflation so it can keep subsidizing the wounded banks with easy money. But the market could lose confidence in the Fed’s theory if the CPI remains stubbornly high at the same time as unemployment remains high. The market would express this view by selling off long-duration Treasuries, which increases yields. If this happens, the Fed will have to tighten policy to restore the market’s confidence in the integrity of paper dollars. Fed tightening would lead to a reacceleration of the unwinding of the commercial real estate bubble.

Consensus view on Treasury supply required to fund budget deficits: “Even though US household savings may absorb just a few hundred billion in Treasuries in 2010, foreign investors and US banks will buy enough to keep yields from rising.”

Alternative view: Several sources estimate that the US Treasury must auction roughly $2.5 trillion in new securities in 2010. Some of the proceeds will retire maturing securities, while the balance will finance the budget deficit.

The majority of the Treasury securities auctioned in 2009 were bills with very short maturity. The average interest rate paid on the Treasury bills auctioned over the past year is roughly 1%. But recently, Treasury auctions have been weighted more toward the longer maturities. Supply could overwhelm demand, causing prices to fall and yields at auctions to rise.

Because banks are choosing to defend their souring bubble-vintage loans, and writing them off slowly over time, they won’t have the capacity in the “hold to maturity” section of their balance sheets to absorb as many Treasury securities as the market expects. If banks had flushed most of their bad loans off their balance sheets in 2009, they would have capacity to absorb perhaps hundreds of billions in Treasury securities in 2010. But they didn’t.

There is a scenario in which domestic demand for US Treasuries could exceed new supply in 2010: another stock market meltdown similar to the one in late 2008. If enough investors flee stocks in a panic and invest the proceeds into Treasuries, yields could go down.

But considering that the government has committed its balance sheet to bailing out the financial system, that scenario is unlikely. More likely is a scenario in which investors question the integrity of the US balance sheet. The way to do that is to sell Treasuries. This scenario would be negative for the stock market, likely sparking the next leg of the secular bear market – a leg that involves several years of the S&P 500 trending gently lower under a rising interest rate environment. But it wouldn’t likely involve a 2008-style panic liquidation of stocks.

Consensus view on the existing stock of Treasuries held by foreign investors: “Year after year, Treasury bears predict that foreign appetite for US Treasuries will weaken, but they keep buying. Foreign central banks will maintain their appetite for Treasuries because they have to keep their currencies cheap or pegged to the US dollar.”

Alternative view: Foreign investors must be willing to hold Treasuries at a yield that compensates them for the risk that inflation and interest rates might go up in the future. If these investors fear that future inflation, interest rates, and deficits will remain dangerous, they won’t buy more Treasuries until yields rise to higher levels.

A financial market that’s evolved to a state at which it requires a perpetually growing inflow of new money to remain stable is a Ponzi scheme. The market for tech stocks in 2000 and real estate in 2006 had evolved into a Ponzi.

Those who argue that foreign creditors will never sell Treasuries because it’s “not in their best interest” should explain why investors sold tech stocks or housing when they were in bubbles. Surely, it wasn’t in the best interest of tech bulls to sell. Selling meant prices would fall, thereby damaging the value of tech stock positions. But they sold aggressively, because they perceived it to be in their best interests.

The situation of foreign creditors holding an unpayable mountain of debt of a trading partner is a classic “prisoner’s dilemma.” A prisoner’s dilemma is a situation in game theory in which two parties might not cooperate even if cooperation is in their best interest. China and Japan might both conclude that buying more US Treasuries is not in their best interest. If they both stop buying at the same time, prices will fall and yields will rise.

This scenario, by the way, is the reason that the responsible American public is opposed to Keynesian deficits as far as the eye can see. Just because Keynesian pro-deficit policies plug a theoretical hole in “aggregate demand” doesn’t mean they are sustainable or wise. The public understands that Keynesian deficits are unsustainable. The cumulative effects of these deficits – which are never offset by surpluses during the good times – ultimately destroy confidence in both the government bond market and the currency.

When the Japanese government hits the debt wall in the next five years and Japanese bond yields spiral upward, it will prove the foolishness of Keynesian policy.

Here is where the existing stock of US Treasuries comes into play. Japan already owns $750 billion worth of Treasuries. When the Japanese government hits the debt wall and yields rise, the Bank of Japan will likely print new yen to fund the government. If so, the value of the yen could collapse, which would force the Japanese Ministry of Finance to sell some of its $750 billion in US Treasuries in order to defend its currency.

It remains to be seen how long the government and the central bank can keep savers involved in this Ponzi scheme. This scenario – if Japanese savers abruptly lose confidence in their government’s ability to service its massive debt load with taxes and bond market proceeds – is how Japan could shift quickly from deflationary conditions to hyperinflation.

Japan is several years ahead of the US in the transformation of its government bond market into a Ponzi scheme, so we should consider it a canary in the coal mine.

Aside from Japan, the appetites of two other huge Treasury investors are waning. The Chinese are rolling their maturing notes and bonds into buying shorter maturity bills. And the Social Security trust fund is not far from being in the position where it’s a net seller – rather than a net buyer – of Treasuries. With unemployment stubbornly high, less payroll taxes are flowing in. With lower payroll tax inflow in 2010, the trust fund has less of a surplus to invest into Treasuries. When demographics switch the trust into a deficit position, it will become a net seller, rather than a buyer, of Treasuries.

All of these factors argue convincingly for rising Treasury yields in 2010 and 2011. The consensus does not seem concerned about these factors. As of Jan. 20, the FTSE NAREIT Equity REIT Index yields 3.72%. This is roughly equal to the 3.64% benchmark 10-Year Treasury yield. Over the past 20 years, the average spread of the NAREIT index over Treasuries was 100 basis points, or 1%. Removing the influence of the 2005-2007 REIT bubble takes the historical average spread closer to 300 basis points over Treasuries.

So not only are REIT valuations at risk from rising Treasury yields, they’re also at risk from rising spreads over Treasuries. Considering that REITs are in a prolonged post-bubble environment, it’s reasonable to assume that REIT spreads over Treasuries will rise to 300 basis points or more. Assuming both factors – rising Treasury yields, a rising spread of REIT yields over Treasuries – the REIT index could easily fall 50% from current levels.


Dan Amoss
for The Daily Reckoning