Flight to Safety

Continuing from the post below:

1. Some time back, the FED decided to hold the federal fund rate between 0 to 25 bps.
2. The 3M t-bill rate touched 0%.
3. 30 yr TSY yields are currently at 2.6%

Such low yields for treasuries imply a strong deflationary/depressionary expectation among market participants.

Let us now consider the following scenarios:

1. Inflation: With most central banks providing free money to the markets in a coordinated effort to ward of a global depression, it is only a matter of time before market participants regain their calm and start taking advantage and treasury yields become negative on a inflation adjusted basis.
2. Crash: As soon as there is any hint of a recovery, money managers who have parked their funds in treasuries will start selling to invest in other asset classes not ready to miss the next upturn.

Which brings us to the question, who is going to fund the US fiscal deficit now? Treasuries will certainly have to yield more for anybody to be willing to invest in them. Assuming that Paulson lives up to the Goldman name, with TARP, he has not only created the world's biggest hedge fund, but if the markets recover, he will have earned the US Treasury enough money for them to pay back all their fiscal deficit. If such rosy scenario does not unfold, 126 bps will be a small price to pay for as 5yr USTSY CDS.