Treasury bonds are becoming less special

A baseline assumption in asset allocation, regulatory policy and international finance has long been that U.S. Treasury securities are risk-free assets that offer protection against the vagaries of economic fortune. It may no longer be valid.

The big picture: That's the cold reality that lurks beneath the rise in longer-term bond yields in recent weeks that triggered a Treasury Department intervention.

• It implies a world where the U.S. government can't count on favorable borrowing conditions as a matter of course.

• Rather, the U.S. is competing in global capital markets in which individual investors, financial institutions and foreign nations will finance massive U.S. deficits only to the extent that Treasury securities offer superior risk-adjusted returns to the alternatives.
• Those are the implications of a new paper by Stanford economist Hanno Lustig published by the Aspen Economic Strategy Group — only further affirmed by developments since the paper was originally drafted.

Zoom in: Lustig finds that investors no longer pay the premium they once did to purchase Treasury securities over comparable investments like highly rated corporate debt or less-liquid bonds of other nations.

• The traditional risk-on/risk-off investing framework — in which Treasury bonds tend to rise in value when stocks fall and vice versa — has fallen apart, with the two asset classes routinely moving in tandem.
• More foreign institutions are diversifying away from dollar assets.
• Large banks, meanwhile, have pulled back their role in the Treasury market, and the Federal Reserve is seeking to get away from owning large pools of Treasuries.

Zoom out: Add it all up, and more of the financing for America's $2 trillion annual deficits is coming from investors who buy Treasuries because they like the interest rates they pay, not because they are the world's safest investment.

What they're saying: "Government debt is safe only when bondholders believe that the Fed will raise rates against inflation and that the fiscal authority will raise taxes against spending shocks," Lustig wrote in "America's Risky Debt: What Markets See That Policymakers Don't."

• "Post-COVID, investors appear to have lost confidence in the second leg. Taxpayers no longer absorb fiscal risk. Bondholders do, and Treasury valuations respond to fiscal shocks."

The intrigue: Lustig warns that U.S. policymakers, with their view of Treasuries as always and forever safe assets, have responded to spikes in yields as "plumbing problems," reflective of technical factors, rather than a market verdict on the government's creditworthiness.

• This blunts the signal that markets are offering, he argues, and amounts to a form of financial repression.
• "Market participants and policymakers are using competing models of US government debt," he wrote. "The market has moved to a risky-debt model that is a better fit for the data," while central bankers and regulators "still operate under the safe-debt model embedded in their analytical tools and prudential rules."

Of note: While Lustig's paper was published online on Aug. 20, it was prepared weeks ago, before the Treasury's $4 billion buyback of long-term bonds in response to higher rates was announced.

Disclosure: Neil is a member of the Aspen Economic Strategy Group.