There appears to be great confusion over the recent rally in US Treasuries.  While US politicians play political chicken and bounce around a potential default, bonds just refuse to sell-off.  And America’s economists are confused.

A comparison that has been going around in recent days is between Japan and Italy.  And Japan is in many ways analogous to the USA in this environment.  The overarching similarity is an autonomous monetary system.  But this appears to slip past the brightest economists.

Paul Krugman takes a crack at why Japan’s bond market remains oblivious to its issues:

“What is true is that the Bank of Japan is keeping rates at zero, while the European Central Bank seems determined to raise rates. Is that enough to explain the difference? Or is it something about the absence of a proper lender-of-last-resort function?

Or, finally, do Japanese politics — for all their disappointments — just look more mature than those of Italy?

I actually don’t have a firm view. But it seems to be an important puzzle to resolve.”

Scott Sumner later added his own thoughts to the subject.  And this morning James Kwak is asking the same question about US Treasuries.

But there’s something far simpler occurring here that consistently causes a huge amount of misconception in the markets and economic circles where the “best” thinkers dominate the agenda with their defunct gold standard paradigm.  Edward Harrison at Credit Writedowns provides the answer to our headline question:

“But when I see Italy and Japan, I think currency sovereignty: the ability, not the willingness of government to hand you another paper IOU with the exact same amount printed on it” when you present it with an obligation in the currency of account.

Japan has currency and inflation risk and all the other risks I outlined but it has an infinite ability to hand you government-created IOUs. Italy does not and can be bankrupted as a result. It’s as simple as that.”

Ding ding ding!  Someone give Edward a gold star.  There’s no such thing as Japan “running out” of Yen.  Just like the USA can’t run out of US Dollars.  So bond markets essentially focus on one facet of the market – the inflation risk.  As we all know, Japan is still battling very low inflation.  And the USA can’t seem to get much traction going on the inflation front either.   So why aren’t treasuries cratering?  Because there’s no such thing as an autonomous currency issuer “running out” of the currency that they have an endless supply of.   As Edward said, “It’s as simple as that.”


Got a comment or question about this post? Feel free to use the Ask Cullen section, leave a comment in the forum or send me a message on Twitter.

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  1. Should be interesting to see if the 30 year plays catch up. Seems to be lagging with the debt ceiling fiasco.

  2. I’m still not understanding why long bonds keep rising, seemingly predicting a deflationary long-term bias, and gold and silver are still shooting to the moon, almost predicting an inflationary currency collapse. Both long bonds and gold are huge markets, so you would think they would both be very efficient, but they seem to be going in opposite directions? I don’t get it.

  3. Japan has an investment surplus with the world, so one thing always on the back of the mind of every Japanese investor is Yen strength when all that money comes home. That probably creates a perception that they should take some “inflation” risk by holding JGBs vs. currency risk. The US is the remaining superpower; people buy treasuries because of strategic global uncertainty (political and capital). There may be a similar trajectory between the two, but it’s not guaranteed by monetary mechanics as it’s all psychology.

  4. Gold investors may be considering gold as an alternative form of money. In deflation, money is valuable. Perhaps both markets are right.

  5. Cullen,
    MARK CUBAN ON BILL MAHER! YOU WILL LOVE IT! “USA cannot be compared to Greece. The USA can print money – Greece can’t.”

    Bet you he is on this website…Cuban, speak up…

  6. In this country: ‘Foreign is better’ and let’s face it Japanese cars are a great calling card. The Japanese are great engineers and they sell at a reasonable price. Better to have great engineers and not so great economists than the other way around.(if you have an export driven economy)

  7. Why are gold and bonds both going up? They each have their separate admirers with little overlap. The market is not one mind.
    By the way, I would not call the physical gold market “huge” compared to currency and treasuries.

    Actually, under deflation you would want to own gold mining stocks instead of gold. Their costs would crater while the purchasing power of the product increases.

  8. The comments on inflation risk being the driver are spot on. Remember that for commodity inflation to become general inflation people need to have more $ to buy the same amount. With high unemployment it just means we do with fewer goods and the reduced demand forces companies to discount back. In the 70’s wages were going up. The Fed’s focus on “core” inflation and low rates indicates they are willing to let us deal with the commodity vice and force us to invest in lower yielding bonds to get a decent return.

  9. Not only that but they’ve definitely got the 14th Amendment covering their backsides.

    The US will pay back its Treasuries, even if that means tearing up cheques to Social Security recipients.

  10. The money is already at home.

    If you’re a net exporter the world gets your goods, and you get your own money back, plus a load of foreign money you had to buy so that people could buy your goods.

    Most JGBs are owned by Japanese banks and insurance companies (about 74%).

  11. SOME money is more valuable than other. I would reefer to the “Is gold money?” thread… Gold can be a store of value or money of exchange, but it’s not currently money in the strict sense of the word (unit of account to settle debts).

    The price of gold (see? price of gold, gold is valued in ‘something else’) is due to it being an hedge against volatility and tail risk IMO. If euro crisis would be solved I think price of gold would drop quite a bit actually.

  12. Zachs newsletter says that people are beginning to question the safe haven status of treasuries.

  13. Not sure I understand. Say for example, China was to sell their US Tsys, and all else remains the same, wouldn’t the RMB go up? (I.e. this is just the corollary to them buying Tsys to keep the exchange rate constant.) The comment on the Japanese external investment position is just something I’ve read in Bloomberg, so maybe I’m wrong there (although it’s certainly correct for the central bank, since they, like china has been buying Tsys).

  14. Zimbabwe can print money also, and it’s made them the most over-indebted nation in the world!

  15. Markets are pricing in ensuing downturn via Europe, Chinese growth slowdown and US fiscal tightening. Gold is up on realization that countries around the world will print to get economies back on track, bonds are up because the Fed will leave rates low for longer.

  16. Both bond and gold investors want a safe secure investment to preserve their purchasing power. Bondholder prefer bonds because they get a monthly coupon to compensate for inflation, risk and time. Gold holders forgo the coupon (though they could lease their gold out) because the real interest rates are low and they think they will come out ahead of bondholders in terms of purchasing power through price appreciation particularly if US exchange rate continues to soften (or inflation increases). Also bonds and gold (as well as the USD) all tend to rally as a safety trade (war, uncertainty etc), so they have that in common too.

    Gold is more sensationally presented as a hedge against bond default or currency/hyperinflationary collapse by speculators. And I think Cullen has done a good job detailing the unlikelihood of default and low probability currency collapse. And most reader are aware that the default risk still exists in Europe. That said, it doesn’t stop speculators from pitching that “marketing” story of collapse to further propel precious metals, perhaps because it better appeals to investors.

    And gold increased in price during deflationary periods in Japan but I tend to agree, that miners may do better during deflationary bouts.

  17. Apart from a couple of deflationary scares in 2008 (financial crisis) and 2010 (euro sovereign debt crisis), the long Treasury yield has been in a broad range of approximately 4.00 to 4.75% for several years. The recent move has been cool, but it is still well within the range. Long Treasuries need to break below 4.00% before they get interesting.

  18. Although I understand what Cullen is saying, and it appears to be incredibly insightful, spot-on… it really, really scares me.

  19. The idea that I could make substantial bets on the stupidity of other people, and succeed in doing so, just doesn’t compute. That’s why I have been underperforming for years, I’m confouded by the the mixture of the counter-intuitive forces in the market coupled with the irrational behavior of people. Taken separately, I might be able to deal with a simple contrarian driving force. But mix that with a confused investing community, and I have no chance.

    Together, these two ingredients make it all feel like a giant Vegas roulette wheel to me. My hat is off to folks like Cullen, and other investors out there who really get it. This is no easy game. I feel like this market has finally gotten the best of me, and I have basically given up. I am holding cash and real-estate. It was thinking that cash would be a good deflation hedge, and real-estate (once the inventory picture begins to normalize) would be a good inflation hedge. Am I an idiot? Any help would be appreciated.

  20. People purchase gold for reasons other than an inflation hedge. During WW 2, with people’s countries literally blowing up around them, gold was a universal bartering commodity that allowed them to travel while seeking refuge from the slaughter. With the unprecedented uncertainty gripping the world today its no surprise folks are displaying a “flight to safety” that gold represents.

    Fear of inflation, and fear of uncertainty, are but two reasons people buy gold. I’m sure if you Google, “why people buy gold,“ you’ll find many more.