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posted on 23 February 2016

Rich Or Poor, You Cant Ignore U.S. Treasuries In Todays Markets

by Keith Fitz-Gerald, Money Morning

Money Morning Article of the Week

There are a good number of investors who believe that U.S. Government Treasuries - notes in particular - are bad for you and even worse for your money at the moment. Why really doesn't matter... rates might rise, deflation, a bond market bubble, there's too much debt... they're riskier than you think, goes the argument.

All of those things are, well... true.

Yet, I submit U.S. Treasuries are the one investment you cannot afford to be without at the moment for three reasons:

  1. Treasuries help reduce your overall portfolio volatility (which is especially critical at the moment as part of a disciplined investment approach like the 50-40-10 Portfolio I advocate in the Money Map Report).

  2. Treasuries are still valuable and becoming more so as the Negative-Interest-Rate Club grows (for reasons I'll explain in a minute).

  3. Treasuries are the last thing our government will let fail (because they're the first thing politicians will protect).

So grab a cup of joe and let me share something with you that escapes 99% of all investors.

Cut Volatility in Your Portfolio by 63% - Maybe More

Again, I know the arguments.

High demand and low supply makes big moves inevitable at a time when the average investor desperately craves stability. Treasuries are not the completely risk-free investment they were years ago.

Still, neither of those things changes the fact that you need to own them.

Not just any old Treasuries will do, though.

You want to confine your purchases to short- and intermediate-term notes right now. Ideally, you'll want to buy government bonds with a duration under five years as part of a disciplined investment approach like the 50-40-10 Portfolio we follow as part of the Money Map Method.

I'll explain duration in a moment.

But first, in case you're not familiar with the term, a Treasury note is a security that has a stated interest rate with a two, three, five, and 10-year term that's paid semi-annually until maturity. T-bills and bonds are technically different; the former has a maturity of under one year while the latter has a term of more than 10 years.

The reason you want the shorter-duration notes is that buying them not only helps you get around the massive drop in value that will happen if the Fed raises rates further, but also ensures you avoid most of the volatility that will affect longer-term bond holders over time.

U.S. Treasuries

How much stability are we talking about here?

Try 63%, according to Barclays.

U.S. Treasuries

My own research agrees and suggests that the figure may be closer to 70% under current market conditions, incidentally. But that's a story for another time.

Let's get back to duration.

If you've just joined us, duration is an advanced bond concept that measures interest rate risk. You can earn a Ph.D. studying the nuances.

What you need to know to use it profitably is far simpler.

Duration measures how much bond prices are likely to change when interest rates move. Every 1% increase or decrease in interest rates translates into a 1% move in duration in the opposite direction.

For example, if you own a bond with a five-year duration and rates rise by 1%, then your bond's price will drop by approximately 5%. If rates fall by 1%, your bond's price will rise by 5%. Prices and rates always move in opposite directions.

So, for example, if you see me on one of the networks talking about how Treasury yields have fallen on a given day, you'll know that bond prices have risen without even having to look. At the same time, you'll also know that it's highly likely that this will be because equities - stocks - are falling and traders are looking for safety.

The reverse is also true. If I'm talking about yields rising, that's because bond prices are dropping. And, by implication, equities are probably headed higher as traders feel like taking on more risk.

If this is making your head spin, you're not alone. Many so-called financial professionals go their entire careers and never fully understand what I've just shared with you.

But there's a method to the madness.

Right now the world is a crazy place. Nothing adds up - from the employment data to the squeeze in our wallets we're all feeling thanks to the hopelessly convoluted Fed model that supposedly guides us all. Then there's the geopolitical situation, which is deteriorating by the minute.

It's no wonder the academics can't make heads or tails of things. A rational person would question why the models are no longer working and make changes accordingly. Yet, policy wonks are simply trying more of the same old solutions and desperately hoping to force reality into their equations when it simply won't fit.

Traders on the other hand don't have this problem. They actually move trillions of dollars of real money every day and, as a result, they're the ones that you want to watch.

Right now they are focused on something that's almost never discussed when it comes to the vagaries of bond markets... an estimated 75% of all U.S. Treasuries may never be sold.

Think about that for a minute.

What this tells you is that traders - remember, the guys who move real money - are so concerned about uncertain market conditions that they'd rather buy Treasuries and hold them than sell them.

Logically, you have to wonder why.

Succinctly put, they're worried more about the return of their money than the return on their money that Yellen blathers on about when she gets going on rates. So they're perfectly content to hoard U.S. Treasuries at the moment.

That's why the total Treasury inventory available to market makers in 2007 of $2.7 trillion in 2007 stood at only $1.7 trillion last spring, according JPMorgan Chase CEO Jamie Dimon. Confidential estimates from traders I talk with regularly suggest that figure may be as low as $1.25 trillion right now. If that's correct (and I think it is), that's a 42% drop in marketable Treasuries that makes short-term notes far more valuable than everybody using a conventional academic model thinks.

There's another angle that exacerbates the problem and further confounds Team Yellen's policies - negative interest rates - and that makes the case for owning short-term Treasury notes still stronger.

The markets flipped out on Feb. 4 when Japan's central bank went from ZIRP to NIRP - zero-interest-rate policy to negative-interest-rate policy. Headlines screamed "surprise."

For the life of me, I don't know why.

More than $8 trillion of high-grade government debt is now trading at a negative yield - meaning the bonds have gotten so valuable that yields are below 0%. Japan simply joined the club and followed the European Central Bank, Switzerland, Denmark, and Sweden down the proverbial rabbit hole.

Mark my words, the United States will follow.

Yellen will make the same fundamental mistake in an attempt to force banks to lend the reserves they're stacking up, a good portion of which is held as - you guessed it - U.S. Treasury notes.

People think this is impossible because they view a rate cut in isolation. Yet, according to The Telegraph, monetary policymakers around the world have already cut rates a staggering 637 times since March 2008, even as their central banks have purchased $12.3 trillion in assets over the same time frame.

The global financial system came to the brink of collapse in 2008 with only $142 trillion in global debt. Now the high priests of finance have increased it to $212 trillion. This is the financial equivalent of giving an alcoholic another drink on the assumption that it will help him fix his addiction.

You and I can debate the merits of these moves until the cows come home, but that'd be missing the point... high-grade sovereign debt is the first and last thing governments around the world will protect.

U.S. Treasuries

Starting with short-term U.S. Treasury notes.

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