By Jeff Clark
No matter what happens with the Fed next week, bond prices are set up to fall.
Lately, I've been spending a lot of time watching the action in the Treasury bond market and shaking my head in disbelief. It is baffling to me that anybody would be willing to lend the U.S. government money for 10 years at 1.5% or for 30 years at 2.6%. Heck, the average welfare recipient has better financial statements than the U.S. government.
Think I'm exaggerating? The U.S. government routinely spends 50% more every year than what it takes in. For example… this year, the government plans to spend $3.7 trillion. But it only expects to receive about $2.4 trillion in tax revenue. It makes up the difference by borrowing the money.
That would be like you taking a cash advance for 50% of your salary on your credit card every year… and never paying it down. You couldn't get away with doing that for very long before your creditors cut you off. (Welfare recipients can't do that.)
But the U.S. government can – which is why Congress has to constantly raise the debt ceiling and why the U.S. now owes nearly $16 trillion in debt. That's more than 100% of our total gross domestic product. And we haven't even addressed the $50 trillion or so in unfunded liabilities and the upcoming expenses of the new Obamacare program.
Think about this for a moment… Imagine walking into a bank and asking for a loan. You explain to the friendly banker that you make $100,000 per year but you spend $150,000. You already owe $700,000 in debt and that amount is increasing every year at an accelerated pace. You also have $2.1 million in other obligations and are planning to increase that debt by at least $50,000 every year.
Do you think the banker is going to lend you money for 10 years at 1.5%?
Of course, the government gets away with it because it has the power to print money. But that only further highlights the stupidity behind buying Treasury bonds at such low interest rates. The official inflation rate is running at 2%. That means buyers of 10-year notes are already losing purchasing power every year. But just imagine the potential for higher inflation as the government attempts to print itself into a better financial condition.
Buying Treasury bonds right now – at historic low yields – just doesn't make any sense.
So why on Earth is everybody piling into the Treasury market?
Well… the argument you hear most often is that Treasurys are a "risk-off" trade. Investors are so concerned about the potential for a financial collapse, they're willing to accept a miniscule return in exchange for the safety of being backed by the full faith and credit and the money-printing ability of the U.S. Treasury.
At first glance, this sort of makes sense. After all, it's hard to find another time in history where there was more potential for financial market disruption. Europe is on the verge of imploding… and many of the largest European banks are teetering on the edge of the abyss. California's municipalities are declaring bankruptcy one by one. Agricultural commodity prices are skyrocketing higher. Corporate earnings are falling. Commodity trading firms, like MF Global and PFG Best, are stealing customers' money. Multinational banks are openly colluding to "fix" key interest rate levels. The U.S. government's deficit spending is spiraling out of control. China is failing. The U.S. economy is drifting into a recession. And tax rates are set to ratchet higher.
So sure… we can argue investors are buying Treasury bonds because they're scared to death of buying anything else. But that's simply not true. Investors aren't worried at all. Despite all the previously mentioned concerns, the U.S. stock market is still up on the year. Gold and other precious metals have been selling off. And the Volatility Index – a widely followed measure of fear – is barely up off its 52-week low.
Investors aren't fearful at all. In fact, they seem downright complacent.
Buying Treasury bonds doesn't look to me at all like a "risk-off" trade. It's actually a giant "risk-on" trade ready to explode. Let me explain…
In November 2008 – as Lehman Brothers was going bankrupt, the mortgage market was disintegrating, and the financial world was on the brink of collapse – the Federal Reserve Board made the unprecedented announcement that it would use its money-printing abilities to prop up the price of Treasury bonds and mortgage-backed securities through what it called quantitative easing (QE).
Bond prices rocketed higher and interest rates plummeted as investors realized the Fed would provide a backstop against any adverse move in the bond market. This was the first time the Fed had ever done such a thing. The market was not expecting the move, so it had not discounted that possibility.
Since then, however, the market has done an admirable job of discounting the Fed's willingness to manipulate bond prices. In March 2009, when the Fed announced an increase in the size of its QE program, Treasury bonds actually sold off on the news. Investors were expecting the action and had bought positions in advance of the event. So it was time to "sell on the news." Bond prices fell 15% over the following two months, and they stayed down until June 2010 when the Fed hinted at the possibility of a second QE program.
Once again, investors rushed into the bond market – secure in the knowledge the Fed would prop up prices. Bond prices rose and interest rates fell as the market discounted the future QE2.
By the time the Fed announced QE2 in November 2010, it was time once again to "sell on the news." Bond prices fell 15% over the following four months.
Ever since QE2 ended in July 2011, investors have been betting on QE3. It has to happen. The Fed has to keep up the charade. So folks have been piling into the bond market at record-high prices and record-low rates because they're discounting QE3.
Long-term bond prices are up nearly 40% since QE2 ended last July. They're up almost 20% in just the past three months.
This is a remarkable move. It's the epitome of a "risk-on" trade. Investors are speculating the Fed will announce another QE program, and they're bidding up bond prices to insane levels ahead of the event.
This is going to end badly. And I'm willing to bet it ends next week – after Fed Chairman Ben Bernanke's scheduled Congressional testimony on Wednesday.
You see, it seems just about everybody is expecting more QE this year. The past two monthly employment reports have been disappointing. Other economic indicators are weakening. And there's a presidential election coming up in November, so now is the ideal time to try to goose the stock market higher with a QE announcement.
If it doesn't happen on Wednesday, investors are likely to be disappointed and the bond market is going to sell off.
If we do get a QE announcement next week, we'll likely have another "sell on the news" event.
Either way, it seems no matter what happens with the Fed, next week should mark at least a short-term top in the bond market – if not something even more significant.
Take a look at this chart of the iShares Barclays 20+ Year Treasury Bond Fund (TLT)…
The near-20% rise from April to June has the look of a parabolic top. These moves are unsustainable and usually end with a sharp drop following a retest of the parabolic high point.
To get an idea of what I mean, take a look at this chart of gold from last year…
Gold rallied more than 20% from July to September last year. That's an unsustainable parabolic rise, and the metal dropped $150 per ounce almost overnight after it hit its $1,900-per-ounce high point. The retest of the $1,900 level followed immediately and was accompanied by negative divergence on the MACD indicator.
The setup is similar right now in the bond market.
We took a risk and went against conventional wisdom last year by shorting the gold market into its parabolic move. That was one of the fastest and most profitable trade recommendations we made in 2011.
We need to do the same thing right now with the Treasury bond market.
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