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Treasuries: Not So Safe?


When panic abates, Treasuries will cease to be the trade du jour.


This too shall pass.

And when the financial panic abates, the safety of Treasuries will cease to be the trade du jour. Slowly, risk appetite will return - and those late pulling their money from the Treasury market could face steep losses.

The Wall Street Journal reported yesterday that, since professional money mangers can't park their millions in wobbly US banks, they've flocked to the security and liquidity of the Treasury market.

Government-backed bonds, despite offering essentially no yield, have attracted billions in "smart" money in recent months. As banks failed and credit markets all but stopped functioning, the Treasury market was the only game in town. Seeking the perceived safety of the US dollar, investors drove up Treasury prices and sent their yields towards nil.

But at some point, when the willingness to take on risk returns, investors could leave the Treasury market in droves. If this were to happen, whether it be today, next week or next year, that safe trade may no longer be so safe.

In the past 2 trading days, the dollar -- for which Treasuries offer a proxy investment -- has fallen sharply, giving up recent gains. Shorts rushed to cover profitable bets on falling asset prices - and commodities responded by spiking upwards.

Respectively, gold and crude oil jumped more than 2% and 7% yesterday, while companies for which the price of "stuff" is hugely important, like US Steel (X) and Freeport McMoRan (FCX), soared.

To be sure, one day does not a trend make, and despite the longer term deflationary pressures affecting the economy, the road to lower prices won't be without its share of speed bumps. The massive amounts of liquidity injected into the financial system by the Federal Reserve and multi-billion bailouts of financial giants like Citigroup (C) and AIG (AIG) are, in the short run, inflationary.

Since the greenback is being used around the world as the equivalent of financial toilet paper, a dollar just isn't worth what it used to be. This in turn makes imports more dear and pushes up the price of commodities, many of which are denominated in dollars.

Longer term, however, deleveraging will require the accumulation of dollars to repay debts, driving up its value. The cost of stuff, in dollar terms, will fall. And while this may sound good for a shopping trip, economists fear deflation almost as much as socializing with the opposite sex at the company Christmas party.

To find out why, just put yourself in the position of a store owner, faced with the prospect of selling everything for less. Expansion plans: Postponed. New hiring: Next year. Computer upgrades: Not a chance.

Deflation is an economy's kryptonite.

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