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The Treasury Bond Rush Won't End Well

Conor Sen

(Bloomberg Opinion) -- Many nations in recent years are trying to wall themselves off from the rest of the world, but financial markets are immune: Money is moving freely, showing financial markets at least remain as intertwined as ever.

In Asia, Australia, Europe and the Americas, yield curves are inverting simultaneously. Investors, fearing that the protectionist nations will be successful against globalization, are increasing the demand for the safe assets of dollars and U.S. Treasury bonds. Either the de-globalization fears are overblown, in which case Treasury yields have probably fallen too much, or they're real, in which case global financial market correlations should break down as countries go their own way.

These possibilities show how perverse the pricing of U.S. Treasuries has become.

The first scenario is easy enough: Fears of the breakdown of globalization don't come to pass. In that scenario stock markets get a reprieve and rally strongly as the risk premium from trade tensions fades. The uncertainty causing CEOs to hold off on investment decisions evaporates, and we get at least a short-term boom in investment as delayed projects get built. Global growth turns up, and bond markets sell off hard, with yields rising around the world.

The second scenario requires a few more assumptions. It would seem to lead to bad news for those who have bought U.S. Treasuries this month. Say we get a fairly disorderly breakdown in global trading relationships. As the Wall Street Journal's Greg Ip noted, when assumptions underlying economic eras are shattered, global recessions are often the result. But recessions don't last forever. In the U.S., since World War II the average duration of recession has been 11 months. Given that the U.S. has a relatively closed economy, has households and a banking system in relatively good shape, and isn't an export-dependent economy to the extent Germany or some Asian countries are, any U.S. recession resulting from such a global recession would probably be pretty mild.

And then, coming out of said recession as countries reverted to economies less dependent on foreign trade, global correlations would presumably break down. If the U.S. is going to trade less with China, the U.S. and Chinese economies would be less interdependent, and it wouldn't make sense for their financial markets to move in unison.

We've been hearing for years that globalization has held down inflation in the U.S. as any build-up in inflation pressures has been easy to alleviate by importing cheap goods and cheap labor from abroad, or outsourcing jobs as wage pressures intensified. Those factors would be reduced. Just as increased globalization has led to a convergence in inflation and interest rates around the world, decreased globalization would do the opposite. There's no reason why the U.S. couldn't have 3% inflation even as Germany or China dealt with deflation.

That "new normal" might mean higher inflation and lower growth, which should give pause to investors who have driven long-term Treasury yields to record lows.

It’s understandable why investors have driven yields sharply lower over the past couple of weeks. People are worried about slow global growth and are reacting to negative headlines and tweets. Even as trade and immigration have headwinds, we haven't seen the same for the flow of capital, driving foreign money into the perceived safe haven of the dollar and Treasuries.

But short-term financial market mechanics don't square with the two longer-term economic realities we're confronting. Neither the "breakdown of globalization" nor the "false alarm" scenario seems like good news for Treasury bonds once this moment of uncertainty passes.

To contact the author of this story: Conor Sen at csen9@bloomberg.net

To contact the editor responsible for this story: Philip Gray at philipgray@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Conor Sen is a Bloomberg Opinion columnist. He is a portfolio manager for New River Investments in Atlanta and has been a contributor to the Atlantic and Business Insider.

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