Playing the Coming Bond Market Crash

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By Martin Hutchinson :

Since last November, the U.S. Federal Reserve has been buying U.S. Treasury bonds at a rate of about $75 billion a month. That's part of Fed Chairman Ben S. Bernanke's "QE2" program, under which the central bank was to buy $600 billion of the government bonds.

But QE2 ended Thursday, meaning the Fed will no longer be a big buyer of Treasury bonds. So starting today, the U.S. Treasury needs to sell twice as many Treasury bonds to end investors as it had been.

The problem is, who's going to buy them? Not China, which is diversifying its trillions in assets to get as far away from the U.S. dollar as fast as it can. Not Japan, which is trying to rebound from its March 11 earthquake, tsunami and nuclear disaster -- and is focusing all its spending on reconstruction. And, as we've seen, neither is the Bernanke-led Fed.

I'm telling you right now: We are headed for an epic bond market crash. If you don't know about it, or don't care, you could get clobbered. But if you do know, and are willing to take steps now, you can easily protect yourself and even turn a nice profit in the process.

A Timetable for the Coming Crash

I'm an old bond-market hand -- my experience dates back to my days at the British merchant bank Hill Samuel in the 1970s -- so I see all the signs of what's to come. Having the two biggest external customers of U.S. debt largely out of the market is a huge problem.

Unfortunately, those aren't the only challenges the market faces. The challenges just get bigger from there, which is why I'm predicting a bond market crash.

Steadily rising inflation is one of the challenges. Inflation is a huge threat to the bond markets, and is almost certain to create a whipping turbulence that will ultimately infect the stocks markets, too. Many pundits will tell you that if investor demand for bonds declines, and investor fear of inflation increases, bond-market yields could increase in an orderly fashion.

But I can tell you that the bond markets don't work like that. Price declines affect existing bonds as well as new ones, so the value of every investor's bond holdings declines. And with many of those investors heavily leveraged -- especially at the major international banks -- the sight of year-end bonuses disappearing down the Swanee River as bonds are "marked to market" will cause a panic. That's especially true when end-of-quarter or end-of-year reporting periods loom.

That's why we can expect a bond market crash at some point. If you ask me to make a prediction, I'd say that September or December were the most likely months for such a crash.

A Boxed-In Bernanke

One sad -- even scary -- fact about what I'm predicting is that Fed Chairman Bernanke won't be able to do much about it ... though he'll certain try.

Consumer price inflation is now running at 3.6% year-on-year while producer price inflation is running at 7.2%. In that kind of environment, a 10-year Treasury bond yielding 3% is no longer economically attractive. Since monetary conditions worldwide remain very loose, inflation in the U.S. and worldwide will trend up, not down. At some point, the "value proposition" offered to Treasury bond investors will become impossibly unattractive. When that happens, expect a rush to the exits.

If Bernanke attempts " QE3 " -- a third round of "quantitative easing" -- he will have a problem. If other investors head for the exits, Bernanke may find that the U.S. central bank is as jammed up as the European Central Bank currently is with Greek debt: Both will end up as the suckers that are taking all the rubbish off of everyone else's books.

There's a limit to how much Treasury paper even Bernanke thinks he can buy. And if everyone else is selling, that "limit" won't be high enough to save the bond market. With Bernanke buying at a rapid rate, the inflationary forces will be even stronger, so every Bureau of Labor Statistics report on monthly price indices will be marked by a massive swoon in the Treasury bond market.

Eventually, there has to be a new head of the Fed -- a Paul A. Volcker 2.0 who is truly committed to conquering inflation. It won't be Volcker himself, since at 84, he is probably too old. But it might be John B. Taylor , who invented the "Taylor Rule" for Fed policy. The Taylor Rule is actually a pretty soggy guide on running a monetary system. But it has been flashing bright red signals about the current Fed's monetary policy since 2008.

However, since a Fed chairman who is actually serious about fighting inflation would be a huge burden for President Obama to bear -- and could badly hamper his chances for re-election, any such appointment is unlikely before November 2012.

How to Profit From the Bond Market Crash

Given that reality, it's likely that Bernanke will attack any bond market crash that occurs ahead of the presidential election just by printing more money; there won't be any serious attempt to rectify the fundamental problem, meaning inflation will continue to accelerate.

For you as an investor, this insight leads to two conclusions that you can put to work to your advantage. The scenario I've outlined for you will be very good for gold and other hard assets, and challenging for Treasury bonds; prices will remain weak no matter how vigorously Bernanke attempts to support them.

So what should you do with this knowledge? I have three recommendations. First and foremost, if Bernanke were not around, I would expect gold prices to fall following a bond market crash. But since he's still at the helm at the Fed, I expect him to do "QE3" in the event of a crash. And that means gold -- not Treasury bonds -- would become an investor "safe haven."

You can expect gold prices to zoom up, peaking at a much higher level around the time Bernanke is finally replaced. Silver will also follow this trend . So make sure you have substantial holdings of either physical gold and silver or the exchange-traded funds SPDR Gold Trust ( GLD ) and iShares Silver Trust ( SLV ).

Second, if you want to profit more directly from the collapse in Treasury bond prices, you could buy a "put" option on Treasury bond futures ( TLT ) on the Chicago Board Options Exchange. The futures were recently trading around 94, and the January 2013 80 put (CBOE: TLT1319M80-E ) was priced around $4.50, which seems an attractive combination of low price and high leverage.

Finally, if you don't already own a house, you should buy one -- and do so with a fixed-rate mortgage. A U.S. Treasury bond market crash will send mortgage rates through the roof, so today's rates of about 4.8% will represent very cheap money indeed. Even if house prices decline by 10%, a 2% rise in mortgage rates would increase the monthly payment (even accounting for a 10% smaller mortgage), by a net 11.8% (the payment on a $100,000 mortgage at 4.8% is $524.67; that on a $90,000 mortgage at 6.8% is $586.73).

Needless to say, the same benefits apply to rental properties financed by fixed-rate mortgages: With lower home ownership and rising inflation, rents are tending to rise significantly.

There's a storm coming in the Treasury bond market. But by recognizing its approach, we can turn the bond market crash to our advantage.

See also 10 Takeover/LBO Targets With Low Corporate Governance Risk on seekingalpha.com



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Stocks

Referenced Stocks: GLD , IEF , SLV , TLH , TLT

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