Investors Racing to Safety in Treasurys Could Get Burned

Forest fire
Forest fire

Investors who were shell-shocked from the financial crisis thought they were seeing some light just a few months back. Tentative signs even indicated that hiring was picking up as corporate profits boomed.

But growing evidence of a renewed slowdown over the last few months seems to have shattered the little confidence that had been rebuilt. And investors are now pouring into safe-haven assets like U.S. government debt, pushing yields on the benchmark 10-year bond to rock bottom levels last approached during the depth of the financial crisis.

Investors scrambling to safety at current prices, though, could be heading toward much more risk than they realize. While fears of deflation have been widely paraded, actual evidence of collapsing prices is starkly absent. And some of the shrewdest investors have been exiting Treasurys even as others stream in.

Hardly a Sure Thing

Even with their meager yields, safe assets like Treasurys are a great place to be amid falling prices, of course. The steady income stream rises in its purchasing power, and the lender can see their principal returned upon maturity.

Still, despite the certainty that those tiny yields imply, falling prices are hardly a sure thing. And as with momentum-chasing in other markets, investors need to be careful not to read the piling-on that higher prices can lead to as an airtight verdict on the broader market.

And rallying Treasury prices rather than real signs of deflation may well be what's driving the massive inflows of funds.

Indeed, U.S. producer prices actually climbed 0.2% in July, following an edge up in consumer prices announced last week.

Prices are holding up well overseas, too. Inflation in the fast-expanding U.K. economy is clocking in above 3% -- well above the Bank of England's comfort zone -- thanks partly to a hike in the value-added tax earlier this year.

And despite fears of a deflationary spiral in Europe following a sovereign debt crisis, prices on the Continent lifted to the highest level in 20 months because of climbing energy costs. Excluding energy, prices were still up 1.1% in July following a 0.9% gain in June.

Big Players Who Are Exiting

The reemergence of inflationary fears that were rising quickly earlier in the year could lead to tumbling Treasury prices and a reversal in momentum.

And as funds flow in to prop up prices for the time being, that two prominent investors have been paring back their positions is probably not resonating with the market the way it should.

China reduced it holdings by a record $21.2 billion in June, according to a report released today. And Pimco, the world's largest bond fund, cut its holdings of U.S. government-related debt sharply to 54% of its total from 63% over the same period.

Fearing a double-dip recession, many investors might be racing into what looks like a port in the storm. But if the surprise is to the upside instead, they could be taking on big risks instead.

Originally published