In finance, safety isn't what it used to be. After a couple of money-market funds came perilously close to breaking the buck last week, and given the unsettling inflationary prospects of the government flooding the market with additional Treasury notes to finance the Wall Street bailout, investors are reevaluating what constitutes a "safe haven."
The yield on the three-month Treasury note dropped to zero on Sept. 18, so great was demand for short-term T-bills by nervous investors fleeing equity and money markets. That was of course before Treasury Secretary Henry Paulson announced plans to take toxic mortgage-backed securities off investment banks' balance sheets.
The yield on 10-year U.S. Treasury bonds, at 3.83%, is currently very close to the long-term inflation rate, which means investors would barely preserve their purchasing power if they reinvested all the coupon payments to buy new Treasuries, Marc Schindler, a financial adviser at Pivot Point Advisors in Bellaire, Tex., wrote in an e-mail message to BusinessWeek. He's not alone in believing it's inevitable that yields will rise as the Treasury piles more than $700 billion onto the national debt, which is certain to stoke inflation and weaken the dollar's value.
Bailout Impact
Not everyone is convinced the issuance of a mound of additional Treasury notes will be all that inflationary. Some see it as a much better alternative to printing money to buy distressed assets from banks. The increase in the supply of Treasury notes in and of itself won't spark a big inflation hike unless the bailout helps to resolve the credit crisis and speeds an economic recovery, says James D. King, president and chief investment officer of National Penn Investors Trust Co. in Reading, Pa. If the bailout doesn't work and credit markets don't thaw, further deterioration in business activity will cause unemployment to rise and wages to stagnate or drop, which would offset any increased inflationary pressure, he predicts. The pullback in oil and other commodity prices from summer peaks has already helped relieve inflation risks. The surge in borrowing could also put the Treasury's triple-A credit rating at risk, Pivot Point's Schindler warned in his e-mail.
Investors can buy U.S. Treasury Inflation-Protected Securities (TIPS) to ensure the value of their investment keeps pace with inflation, but they take the chance of lower returns if inflation doesn't climb significantly, since the yield on 30-year TIPS is much lower than on comparable T-bills not adjusted for inflation. TIPS are also less useful for investors in higher-income brackets who tend to report a brisker pace of inflation for the goods they buy—closer to an 8% to 12% rate—than the inflation rate measured by the Consumer Price Index deflator, says Frank Trotter, president of Everbank Direct in Jacksonville, Fla.
A separate risk, though related to inflation concerns, is what damage the further ballooning of the national deficit might do to foreign investors' confidence in U.S. government bonds. One of the prime motivating factors for the nationalization of mortgage giants Fannie Mae (FNM) and Freddie Mac (FRE) was the government's need to assuage foreign investors that had loaded up on the agencies' debt. There is so much foreign money invested in U.S. Treasury bonds that it would only take a small portion of it to retreat to spark a major crisis for U.S. coffers, says Kirk Kinder, a certified financial planner at Picket Fence Financial in Bel Air, Md.
"This is a huge, watershed moment, not just for managing the dollar, but this is the biggest government intervention into our market-based economy," says Kinder. "[Overseas] investors are going to be nervous about investing in the U.S. because we've showed we can change the rules midstream."