If you want to understand why Treasury bonds rallied so powerfully the week following Standard & Poors downgrade of the long-term credit rating of the U.S., it helps to stop thinking of Treasurys as investments altogether.
There’s something counterintuitive about the surge in demand for Treasury bonds across the yield curve at a time when both the U.S. government’s finances and the American economy appears to be shaky. We’re very possibly heading into a recession, our government is seemingly locked in perpetual gridlock, the Federal Reserve is making extraordinary promises to keep a loose monetary policy—and yet people still want U.S. government bonds.
When the bonds of a country such as Greece or Spain get downgraded, they tend to sell off—just like the bonds of a corporation. Weak economic prospects can hurt the bonds of some countries, if the distress is viewed as making it more likely that the country will default. Loose monetary policy is usually bad for bonds, because it can mean that inflation will eat away any interest earned.
So how to explain the moves in Treasury bonds?
As I said, it helps to stop thinking of them as bonds at all. Instead, think of them as government savings accounts. When a sovereign nation, a large corporation, or a huge institutional investor has excess dollars, it needs to decide what to do with them. It can invest directly in businesses, its own or others. It can invest the dollars in corporate bonds and the stock market, either directly or through managed funds. It can convert the dollars into another currency, and invest that currency in foreign bonds and stocks.
Or it can buy Treasury bonds.
A Treasury bond is where corporations, nations, and institutions store money that they aren’t investing. It is the equivalent of a savings account for vast caches of wealth. When other investments seem too risky, the demand for these savings accounts goes up.
Of course, it is possible to use actual savings accounts. But this is just a slightly riskier and more expensive way of investing in Treasury bonds. If Apple moves a bunch of its cash into JPMorgan Chase, the bank will just go buy Treasury bonds with the cash. So, no matter what, it ends up in Treasury bonds.
Every other substitute for Treasurys is riskier or lacks the supply necessary to meet the demand. There are only so many Swiss bonds in the world. Gold is a speculative hedge against future dollar price inflation.
If you want to save, Treasury bonds are where it’s at, baby.
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