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The U.S. Treasury Bond Bubble

Written By Brian Hicks

Posted December 30, 2008

Attempting to escape the clenches of the credit crunch, nervous investors ran screaming toward Treasury bills.

So much so, they drove the three-month Treasury bill rate to negative territory for the first time since 1929, creating an over-inflated bubble set for failure.

Yep, the next bubble is here… and most people can’t wait for it to happen. It may not have the characteristics of the Internet, energy or housing bubbles, but the unbelievable rally in U.S. Treasury bonds is just as doomed as commodities and housing stocks.

You see, most bubbles form because people believe there’s a lot of money to be made. But when the frenzy dies, as it did with commodities, prices come down… hard. With Treasuries, the bubble inflates as people become afraid of other markets.

Eventually, and hopefully, the fear will drain, and Treasury investors will return to stocks and corporate bonds, selling off Treasuries… then pop goes the bubble.

Even Michael R. Sesit, author of Bloomberg‘s "Treasuries Walk, Talk like an Old-Time Bubble," agrees. He’ll tell you it’s tough to argue that the Treasury bubble won’t eventually pop, seeing that a T-bill priced at zero percent is ridiculously overvalued. And we agree with him.

So does Bill Gross of PIMCO fame, who believes that the Treasury market is overvalued and exhibiting bubble-like characteristics. He even acknowledges a doomed dollar:

"Certainly the government and the Fed cannot continue to talk about the trillions of dollars of expansion of the Fed’s balance sheet without the risk of the dollar going south. It is fair to say other economies are doing much the same thing. The dollar doesn’t have to go south if all the economies reflate at the same time."

The Fear Is "When" and "How Big of a Failure" It’ll Be… Not "If."

Fed helicopter drops, interest rate cuts, and big Treasury borrowings can’t keep Treasuries overvalued forever. Plus, we’re watching as financial recipients of the $700 billion bailout plan buy Treasuries to recapitalize and improve ratios, instead of lending the money to customers, which is driving up Treasury demand.

Even banks in Asia and Europe are attempting to recapitalize by buying up U.S. Treasuries.

And the Fed isn’t exactly helping. On November 25, the Fed announced it would buy up to $100 billion in mortgages from Fannie Mae, Freddie Mac, and Federal Home Loan Banks, which will eventually push more money into Treasuries.

And according to my colleague, Steve Christ:

Fed Chairman Ben Bernanke only managed to push the herd even deeper into bonds when he basically admitted the Fed had run out of bullets. The Fed, Bernanke said, could buy "longer-term Treasury or agency securities on the open market in substantial quantities." "This approach," he said, "might influence the yields on these securities, thus helping to spur aggregate demand."

Needless to say, that was music to the ears of traders in the bond pits as they rushed to get in line ahead of a Fed that now seemed determined to force rates lower by buying Treasuries. T-note yields have fallen to multi-decade lows as a result.

And it’s done nothing but create a bubble that’s doomed for failure.

What Happens When the Bubble Pops?

First, according to Sesit, a popped bubble would cause big losses for millions of people, especially those who are retiring and regard Treasuries as safe investment vehicles.

Second, the "pop" could destroy "the international stature of the U.S. foreigners, who own about half of all Treasures…"

And third, a "pop" could destroy any economic growth efforts under the Obama Administration, undermining the "dollar’s reserve currency status."

So how do you profit from the eventual demise?

One way is to buy put options on the obvious play, the iShares Lehman 20+ Year Treasury Bond. The three other ways will soon be revealed to Options Trading Pit readers, following required due diligence.

Stay tuned for more.

Good Investing,

Ian L. Cooper

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