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Bernanke's siren song for U.S. Treasury bonds

The U.S. Treasury building in Washington, D.C. Federal Reserve chief Ben Bernanke last week sketched a gloomy picture of a stumbling U.S. recovery that will keep interest rates at rock-bottom levels well into 2014

Brendan Smialowski/Bloomberg/Brendan Smialowski/Bloomberg

Federal Reserve chief Ben Bernanke last week sketched a gloomy picture of a stumbling U.S. recovery that will keep interest rates at rock-bottom levels well into 2014 and probably will require another stimulus injection.

If "recovery continues to be modest and progress on unemployment very slow and if inflation appears to be likely to be below target for a number of years out … then I think there would be a very strong case … for finding different additional tools for expansion – for expansionary policies or to support the economy," Mr. Bernanke told assembled reporters in this welcome new age of central bank candour.

A couple of days later, a less than robust U.S. GDP number underscored the Fed's dovish message and affirmed the view of bullish Treasury bond investors that their favourite, oft-maligned asset class still has plenty of room to run.

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Buying U.S. and other government bonds made sense for the moneyed hordes fleeing crumbling Europe and anything else bearing a semblance of risk last year. But the lure of far better yields has lately been drawing the less risk-averse back to U.S. equities, high-yield corporate bonds and emerging market funds.

The siren song has familiar, if effective, lyrics. Interest rates have reached all-time lows and have nowhere to go but up – a change of direction that would surely unhinge the unhedged bond investor. Or as one headline in a publication aimed at U.S. investment advisers screamed last fall: "Disastrous Bond Rout Just Up the Road, Experts Warn."

Since then, U.S. rates have slid even further. The one-year Treasury bill sits at about 0.10 per cent. Five-year notes fell to a record low Friday of 0.76 per cent. Ten-year Treasuries hover under 2 per cent and even the 30-year bond is barely above 3 per cent.

So, the argument goes, it's simply not logical to tie up money at real rates effectively below zero when undervalued blue-chip stocks of powerhouse global companies offer far better dividend yields and terrific growth prospects. And if inflation should ever make a comeback, stocks will always fare better than bonds, because they typically provide a return above the rate of inflation, at least in the short term.

Robert Kessler, whose eponymous Denver-based firm, Kessler Investment Advisors, counsels large corporations and financial institutions around the world on U.S. Treasury investments, has heard all this before. And he acknowledges that the equity pitch sounds seductive.

But Mr. Kessler says critics are missing what the Fed made crystal clear last week: Inflation is not looming on the horizon. Indeed, the U.S. has been in a deflationary mode for the past three months, and he sees the effective rate falling below 1 per cent by the summer, as demand weakens. Price pressures are absent in most other countries too.

Thus arguments about real versus nominal rates of return are "pure BS from the sell-side of the street." Indeed, last year, Treasuries delivered not only traditional safety – the return of capital – but real gains for the astute investor.

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"The marketplace isn't being fair about where money consistently is being made."

He is paying particular attention to the five-year U.S. note, which he was piling into even before the Fed signalled its intentions last week. And he says Canadian government bonds offer the same opportunities for risk-free gains.

Investors shouldn't own treasuries because they're patriotic or think the instruments are a good long-term buy, Mr. Kessler says. "You should be buying treasuries because we know more about how this asset class moves up and down than any other. We are constantly being shown everything we need to know. No one can give you a better road map [in any other asset class]"

We also have a fairly good global picture of faltering growth, high unemployment and weak demand that will affect most asset classes, especially stocks and commodities.

World economic growth is forecast to slow dramatically this year, which makes it unreasonable to expect the big, globally exposed companies to post fatter profits, he says. "How can GE earn 10 per cent or more [which it is forecasting]when the whole global GDP won't exceed 1.5?"

Unlike Treasuries, stocks are captives of the indexes. If the S&P 500 falls 30 per cent, chances are each of its components will suffer similar losses, no matter how well insulated they may be from various potential shocks.

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He expects investors will reach the same conclusion and that equities will take a heavy hit by the end of the first quarter.

Mr. Kessler doesn't see anything changing his bullish outlook on Treasuries any time soon. "The whole world is going to turn around in a split-second? No. Japan has been trying to do it for 20 years."

Those who don't agree with him, but still worry about the risks facing stocks can always stick with cash.

"There's nothing wrong with cash. The fact that you don't get any return is acceptable. At least you're not losing any money."

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About the Author
Senior Economics Writer and Global Markets Columnist

Brian Milner is a senior economics writer and global markets columnist. In a long career at The Globe and Mail, he has covered diverse business beats, including international trade, the automotive industry, media, debt markets, banking and the business side of sports. More

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