US economy: Safety net

Treasuries: a poor but safe return
October 17, 2012

A guarantee from the US Treasury is the best in the world for the same reason that a US passport would fetch one of the top prices in an auction of world identity documents. As PJ O’Rourke once remarked, wherever you go in the world you can always recognise the US Embassy: it’s the one with the protest out front and the long queue at the visa section.

Paper currencies are ephemeral things. Everyone knows the story of Germany’s hyperinflation but in fact, even before the advent of the euro, almost all European currencies had been replaced at least once over the course of the last hundred years. In much of Africa and South America it’s been a frequent occurrence. For this to be avoided the first condition is that the constitutional and territorial integrity of the issuer remains intact. The circumstances in which a dollar could not be exchanged for goods in, say, a supermarket in Minneapolis are hard to imagine.

This might seem an extreme starting point for a discussion of the merits of US Treasuries. But even in the best of times, and these are not the best of times, the first questions to be asked of a fixed income investment are the stability of the currency in which it is denominated and the reliability of its guarantor.

For sovereign states that control the issuance of their own currencies—Euroland’s members gave this up when they formed the European Monetary Union—the risk is not so much of default but of being repaid in a devalued currency. Locals find that inflation has eroded the value of their investment. Foreigners find that the exchange rate has moved against them. It is also the case that although bond prices move up and down as interest rates rise and fall, changes in the value of the currency in which they are denominated tend to dwarf these fluctuations. Currency volatility dominates local price volatility.

US Treasuries, and in particular Treasury Inflation Protected Securities (TIPS), are a “safe haven.” A promise from the US is as good as it gets while inflation protection would become very valuable if the present monetary policy experiments go badly. Like most safe havens the price has gone up and the prospective return gone down during the financial turbulence of the last few years. In the early 2000s, when it was believed that the US economy could carry on expanding at four per cent or more in perpetuity, TIPS offered a return of 4.5 per cent over the future inflation rate. Today they guarantee the owner a loss after allowing for inflation, albeit a small one.

Obviously this isn’t a good long term return. There are, however, circumstances (investors in Greek securities have just experienced them) in which there are no good outcomes—just less bad ones. Much of the world economy is struggling and monetary policy is heading further into uncharted waters—with unknown consequences for future inflation. Settling for a poor return with the certainty of avoiding a catastrophic one has its attractions.