The Coming Bond Market Collapse: Three Ways to Dodge the Damage

[Editor's Note: Martin Hutchinson's prediction of a U.S. bond market collapse is the latest installment of Money Morning's "Quarterly Report" forecast series, in which we've been providing you with analyses of gold, silver, stocks, oil and other key investment sectors. For a related forecast story on the U.S. economy that also appears in today's issue, please click here.]

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We're on a collision course with the worst bond market collapse in decades.

The warning signs are as clear as day.

There's still time to dodge the damage – and even to profit – if you know what to look for.

But the time to make your move is now…


Three Catalysts for a "Total Bond Market Collapse"

U.S. Treasury bond yields have been only moderately strong since December, with the 10-year Treasury yield rising from 3.31% to 3.40%. As a result, bonds have been a pretty unprofitable play for investors: In fact, a 10-year Treasury purchased Jan. 1 has lost 0.76% of its principal, which almost wipes out theroughly 1% in interest the bond has yielded during that same 3½ month stretch.

While that only represents a moderate decline in bond prices, take heed: That gentle slope leads directly to the precipice of a bottomless pit – a total bond market collapse.

There are three key factors that will cause – and even hasten – the coming bond market collapse. These catalysts are easy to spot – indeed, they're in the headlines virtually every day.

I'm talking, of course, about monetary policy, inflation and the federal deficit. Let's take a detailed look at each of these potential bond-market-collapse catalysts:

  • The Monetary Policy Blues: U.S. Federal Reserve Chairman Ben S. Bernanke has kept interest rates virtually at zero (0.00%) for 30 months, with inflation now showing signs of returning. Since November, Bernanke's been buying a full two-thirds of the Treasury's debt issuance. He's not going to raise interest rates anytime soon, which means inflation will accelerate, mostly through commodity prices. And when he stops buying Treasuries, where will that leave the investors?
  • The Inflation Conflagration: Inflation had been running at near zero because of the recession, but in the last six months the producer price index (PPI) has risen at an annual rate of 10%. That will feed into the consumer price index (CPI) over the next few months. At some point, bond buyers will realize inflation is back and panic. After all, even though inflation never got above 14% in the 1970s and 1980s, long-term bond yields got to 15%. For bond yields to move that high from here, bond prices would have to fall an awfully long way.
  • The Federal-Deficit Follies: The real cost of the $787 billion "stimulus" of 2009 is the $1.6 trillion deficit we are now struggling with. Money Morning Quarterly ReportThe United States has never run a deficit of anywhere near this magnitude, and it's becoming obvious that trillion-dollar-plus deficits are here until at least 2013. That's another reason for the bond markets to panic – and is another reason to fear a bond market collapse.

Worse Than the 70s

Combine those three factors, and you're looking at the potential for a truly epic bond market collapse, worse than anything that we saw in the 1970s. After all, if bond yields rise 0.25% when the Fed is buying 70% of the bonds and keeping interest rates artificially low, those yields will experience a stratospheric zoom after June 30, when Bernanke's "QE2" bond-purchase program comes to an end.

If you ask me to bet, I would say the bond market disaster will start in the third quarter – even CPI inflation figures are likely to be looking pretty creepy by then. Before then, you will probably see a continuing creep upwards in bond yields, perhaps reaching 4% on 10-year Treasuries by early June.

How to protect yourself? Well, obviously gold and silver are part of the solution, at least until the Fed starts fighting inflation properly, which I don't expect to happen before next year (for specific recommendations, see the "Actions to Take" section that follows).

The other solution is to bet on the bond market collapse itself. To do that, I'd recommend a look at the ProShares UltraShort Barclays 20+ Year Treasury Exchange Traded Fund (NYSE: TBT), which aims to rise by twice the amount that long-term Treasuries decline. Like all leveraged "inverse" funds, this accumulates tracking error if you hold it too long. However, I don't think we'll have to hold it for more than a few months this time, so the tracking error should be modest.

People have been predicting a sharp rise in bond yields for two years now, and they have been wrong. However, I think those predictions of a bond market collapse are likely to come true within the next few months, and when they do, they'll come true with a bang.

Actions to Take: Investors are looking at a bond market collapse, and it could start in the third quarter. But don't wait until then to adopt defensive investments. Start positioning yourself now.

The U.S. Federal Reserve's loose monetary policy and the inability of our elected representatives in Congress to rein in the U.S. debt load have undermined both the U.S. dollar and the nation's economic recovery.

There is no safe place to hide, but owning gold and other precious metals such as silver could go a long way toward preserving your wealth – at least until the Fed starts fighting inflation properly, which I don't expect to happen before next year.

In fact, I would recommend you haveat least 15% to 20% of your portfolio in gold and silver, the traditional inflation hedges. For detailed instructions on how to stock up on these metals see Money Morning's special reports: "How to Buy Gold" and "How to Buy Silver."

Of course, the short story is that both metals have exchange-traded funds (ETFs) that track their price fluctuations – namely the SPDR Gold Trust (NYSE: GLD) and the iShares Silver Trust (NYSE: SLV).

The other solution is to bet on the bond market collapse itself. To do that, I'd recommend a look at the ProShares UltraShort Barclays 20+ Year Treasury Exchange Traded Fund (NYSE: TBT), which aims to rise by twice the amount that long-term Treasuries decline. Like all leveraged "inverse" funds, this accumulates tracking error if you hold it too long. However, I don't think we'll have to hold it for more than a few months this time, so the tracking error should be modest.

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Join the conversation. Click here to jump to comments…

  1. John Walker | April 21, 2011

    Sad to say I own TBT and VXX and they are not performing as advertised. Niether of these funds perform with their benchmark. When bonds drop TLT $.40 TBT goes up $ .20 if you are lucky. The same with VXX it moves up only half as much as VIX. But both TBT and VXX drop much more, they are a big disapointment to me. If you look at a graph of TBT and TLT it will show this, the same with VXX and VIX.

  2. John Stuart Cook | April 21, 2011

    I am interested in getting Money Morning.

  3. Bud | April 21, 2011

    Since the Fed is holding 70% of US debt in bonds then surely it has to raise yields/ interest rates to attract investors back to the bond market and avoid a collapse?

  4. Reed | April 21, 2011

    What about Treasury Inflation Protected bonds (TIPS) Any thought about how these will perform?

  5. BobsYourUncle | April 21, 2011

    John Walker… TBT and VXX are horrible instruments. Don't use them. As mentioned in slight passing at best in this article is the decay effect time has on these vehicles. I would suggest on the bond front to either short TLT or go long a single Inverse bond such as TBF. They don't have the decay. A good idea in shorting Treasury's could be ruined by the decay of TBT, which is why even though I am as greedy as the next guy, I will not play it (TBT). As luck would have it TBF is consolidating on its 200sma ($43.50 area). FYI I am already in.

    The VXX is just a piece of crap. Get it wrong for long enough and it will eat your lunch. Just don't bother with such a POS.

  6. Dave Shelter | April 21, 2011

    Your screwed if you do and your screwed if you don't. As the Fed raises interest rates to make bonds more interesting to buyers, it ends up costing the American tax payer even more money. http://www.shelter101.com/gold-soars-as-us-dollar-sinks-to-2008-recession-levels.html

  7. offshore banking | April 24, 2011

    bond market is like the sport of baseball – you have to understand and appreciate the rules and strategies or else it seems boring. Bond market classifications are briefly discussed followed by calculations pricing and pricing spreads.A basic knowledge of these pricing conventions will make the bond market seem as exciting as the best World Series baseball game. For related reading check out the and tutorials. Bond Market ClassificationsThe bond market consists of a great number of and types of securities.

  8. Rob Smith | August 18, 2011

    This could have been one of the worst predictions in history. Once you make such a rash prediction and are wrong, you may as well go on to your next job…..nobody will buy your newsletter any more! Maybe you should make a few more guesses so you can increase your batting average to .500.

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