“Simplicity is the ultimate sophistication.”
-Leonardo Da Vinci
In February of this year we argued that there is no compelling reason for the existence of positive real rates on “risk-free” sovereign debt (such as U.S. Treasury Bonds), and by extension for an upward-sloping (or any non-flat) sovereign-debt yield curve. The persistence of these phenomena in the past was really the result of investors demanding a “default premium” (akin to that on corporate debt) as compensation for loss due to wars, coups, and currency collapses. The relative absence of these events in the modern, developed world implies that investors don’t require this default premium any longer, especially for the world’s “reserve” currency. Data (shown in the piece) going back 700 years supports this hypothesis. In the months since that article appeared, no one, including economists and market practitioners with whom I have shared it, has mounted a persuasive counter argument.
A natural result of this belief leads to a potentially much simpler and cheaper-to-run U.S. Bond market structure. In place of the current complex system of issuing Treasury Bills in one, three, six, and twelve-month maturities and Notes and Bonds with maturities of two, three, five, seven, ten, twenty, and thirty years via never-ending weekly auctions, the Treasury should issue just one security: a perpetual TIP (Treasury Inflation-Protected bond). This would be a perpetual (no set maturity) security that paid no nominal coupon and continuously returned the rate of inflation (accreting every month, say). It could be purchased directly from the Treasury without the cumbersome dealer auctions that take place today and the current TIPs market would also be eliminated.
Lest we fear that investors would never buy government bonds without a coupon, the evidence suggest otherwise. Not only have investors in Europe (and a few times here in the U.S.) bought billions of debt with NEGATIVE nominal yields, history suggests that the “perpetual TIP” is a much better deal than they have generally gotten. According to The Economist (October 19, 2013), the real purchasing power of investors in U.S Government bonds between 1946 and 1981 was eroded by 91%! It is doubtful that current investors in 10-year U.S. Treasuries at 0.85% and 30-year UST’s at 1.50% are going to garner positive real returns.
Not only would this mechanism make the issuance of government debt cheaper and simpler to run, it would impose a natural check on the government’s desire to use inflation to erode the value of debt (as they did in the post-WWII period), with all its attendant negative consequences. No doubt, bond dealers would howl in opposition to this scheme as it would deprive them of a lucrative government-secured income stream, much as brokers did upon the change to decimal stock pricing in 2005 (replacing 1/8th as the minimal unit). But protecting a monopoly source of income to bond dealers is not a reason to reject reason! It’s time to make the U.S. Government bond market more sophisticated – simplify!
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