For Treasuries to stay safe, U.S. must settle ceiling

The almighty and powerful U.S. Treasury market is roiling with some wild, historic, and unique-yet-disturbing cross currents.

For investors, it's important to make sense of it all, since so many Americans hold Treasuries in their money-market accounts, mutual funds, or a portion of their portfolio in cash.

When Wall Street refers to being in "cash," that generally means investors placing money in U.S. Treasuries as a safe haven.

So is the U.S. Treasury market still a safe haven? So far, so good. But the yields have been dismal. The yield on the 10-year Treasury bond last week dipped below 3 percent for the first time in years. That's bad for investors who are holding their money in those bonds, since the returns are reaching historic lows. When you add in inflation, the real rates of return could start to border on negative.

Congress is now digging in for a fight over whether to raise the U.S. government debt ceiling by Aug. 2. Worries are that if a deal isn't reached by then, the U.S. government might default on its Treasury obligations.

Some high-profile investors are taking sides on Treasuries. Those who got out of them include Bill Gross and his mutual-fund giant Pacific Investment Management. Gross has said for months that Treasuries were a sucker's bet. Another smart-money type, Stanley Druckenmiller, who ran the billion-dollar Duquesne Capital hedge fund, recently told the Wall Street Journal he is buying Treasury bonds, and isn't worried even if they might soon technically default.

Over the next few months, trading in Treasuries is likely to be treacherous, says Kevin Tierney, founder of KJT Investments in New York, a financial-advisory and tax-planning firm for individual investors. He is avoiding Treasuries for now, based on short-term belief that Federal Reserve purchases of bonds manipulate the market, and his long-term belief that interest rates are going to go higher over the next few years.

There are two parts to a bond - the underlying price, and the interest rate, or yield. Once interest rates start going up, Tierney says, he would make a play on rates continuing to rise over the next several years. He would be a buyer of ProShares UltraShort 20+ Year Treasury (symbol: TBT) and ProShares UltraShort 7-10 Year Treasury (symbol: PST); both are plays on rising yields.

"These are still too early to own, and timing is critical," Tierney said. "You have to wait until you know rates are going up, even if you miss the first leg up in rates. Interest rates have to go up, since the Fed has saddled us with debt and ruined the dollar. It's only a matter of time."

But for every 1 percent increase in yield, the underlying bond price drops by roughly 12 percent, Tierney estimates. So a $1,000 bond returning 3 percent would drop in price to $880 if rates rise to 4 percent. The TBT and PST funds are plays on rising yields, Tierney explained.

And what about those default worries? Moody's Investors Service said last week it would put the U.S. government's AAA credit rating under review for a downgrade unless there is progress on increasing the debt limit by mid-July, according to Bloomberg. "The heightened polarization over the debt limit has increased the odds of a short-lived default," New York-based Moody's said in a statement. "If this situation remains unchanged in coming weeks, Moody's will place the rating under review."

Treasury Secretary Timothy Geithner warned that failure to raise the debt ceiling by the Aug. 2 deadline might have catastrophic effects because it would sharply raise America's borrowing costs.

"I'm confident," Geithner said Thursday, "we're going to avoid a default crisis, and we're going to reach agreement on a long-term fiscal plan."

House Speaker John A. Boehner (R., Ohio), on the other hand, argued that Moody's statement underscores the fact that a deal on raising the $14.3 trillion debt ceiling must include plans to reduce budget deficits.

Economists agree: John Mauldin, in his recent book Endgame, points out the keen irony that the U.S. government fails to keep its own financial house in order while regulating corporations and small businesses. "It is illegal for businesses to keep their books the way the government does, hiding long-term obligations the way it hides its indebtedness from voters."

Come later this summer, the government will have to get its books in order - for the sake of all of us who hold U.S. Treasuries.