How to Protect Yourself From the Collapse of Treasury Bonds

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By now, you've probably taken note of the growing bubble in Treasury bonds.

The yield on the 10-year Treasury bond fell below 2% for the first time in 50 years in the wake of the U.S. credit rating downgrade.

That's irrational, and more importantly, dangerous.

A Treasury bond bubble is a unique creature. In fact, it's never been seen before, so determining its fate requires some careful thought.

But what's absolutely certain is that U.S. Treasuries are not a safe haven investment – far from it.

Treasury bonds carry five very dangerous risks – including negative yields, higher inflation, panic selling, an outright collapse, and default.

So let's take a closer look at those risks before determining the best way to profit.

First, real yields on Treasuries, after accounting for inflation, are now negative. Not only are nominal Treasury yields below the current inflation rate, but 10-year Treasury Inflation Protected Securities (TIPS) have traded on a yield of less than zero.

That is very unusual and economically distorting. Long-term bond yields in the zero-inflation 19th century never fell below 2.2%, which is to be expected. The guy who provides the money should get paid for doing so. However, any reversion to historical patterns would cause a major bond bear market. Ten-year Treasury yields would rise to the 5% to 6% range – even if inflation gets no faster – giving investors a 27% mark-to-market loss.

Of course, inflation will accelerate.

The consumer price index (CPI) inflation is up 3.6% from last year. And it's likely to rise much further as a result of the Federal Reserve's loose monetary policies.

If inflation were to rise to 10%, which is perfectly plausible, bond yields would have to rise to 12% to 13%, giving investors a 59% mark-to-market loss as well as eroding the value of their principal.

Yet there's an even greater threat than inflation, and that's the U.S. budget deficit. The United States is currently running an annual $600 billion balance of payments deficit. That deficit is being financed through the sale of Treasuries to foreign buyers.

Should foreign buyers cease buying, the dollar would have to fall to equalize the payments balance, perhaps by 20%. As a dollar investor, you might not mind this (though it would increase inflation). But foreign investors will hate it. The likely result would be the panicked selling of Treasuries, which would cause yields to rise sharply and prices to fall.

Finally, there's the risk of an outright default. Short-term, that's an infinitesimal risk – but a risk nonetheless.

After all, Treasuries used to be thought of as "risk free." Now, following the S&P downgrade, they are considered "low risk."

If the public repeatedly elects politicians who can't or won't take effective action to cut spending, particularly in the entitlements area, then debt eventually will spiral out of control and become impossible to repay.

You're probably free from this risk in five-year Treasuries, but not in 30-year Treasuries.

Theoretically, governments can't go bust in their own currency, since they can always print money. But that's nonsense. There comes a point at which you have to wheel the stuff around in barrows to buy groceries – as was the case in Germany in 1923. At that point, governments have to default – there's no alternative.

With such a broad collection of risks, Treasuries should be avoided like the plague. One or more of these five wealth-destroying events will almost certainly come to pass.

So here's how to protect yourself.

To profit from rises in Treasury bond yields, you might consider the Rydex Inverse Government Long Bond Strategy (MUTF: RYJCX), the price of which is inversely linked to T-bond prices (the fund shorts Treasury bond futures.).

Another alternative is the ProShares UltraShort 20+ Year Treasury ETF (NYSE: TBT), which rises by double the amount the 20-year T-bond future falls – but be careful with this one, it has to rebalance its portfolio each day, so if prices jump about, its value quickly erodes.

However, those won't protect you against currency losses or inflation. To avoid currency losses, buy a foreign currency, perhaps Australian dollars, Canadian dollars or Swiss francs. To avoid inflation, go for gold.

Nothing can protect you completely against the bursting of the Treasury bond bubble – it will have an adverse effect on the economy as a whole, affecting all your investments and possibly your business or employment.

Still, you can mitigate the problem with the right investments.

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  1. Richard | August 29, 2011

    TBT was recommended by you in April at US$35. It is US$25 now. My decision is whether to bail due to volatility erosion or stick with it.

    • fallingman | August 29, 2011

      If I might humbly suggest that TBT will be fine. When the bounce back comes, it'll be ferocious, but it could be a while.

      With the erosion you get in these *$%# inverse ETFs, your best bet is probably to consistently sell call options against your long position whenever you're in them. You make money on the normal erosion in time premium AND on the steady erosion in the ETF's value. Otherwise, if you get the timing wrong, you lose a little bit of ground every day.

      Overall, TBT is fine for a short term play, but the the mutual funds are better for a long term play. Selling covered calls option sales can easily make up for the slight disadvantage, however.

    • tom | September 4, 2011

      You must be crazy to listen. Invest in gold stock. Gold will be $2300.00 per oz by first quarter of 2012.

  2. david tarbuck | August 29, 2011

    AAA or B- or anything in between, USA's or anyone elses', Treasury Bonds are just "ficticious capital". Promises, promises, promises that when the going gets tough default at least partial as in devaluation is inevitable!

  3. Werner | August 29, 2011

    Martin, you are probably the first American – or more widely speaking Anglos-Saxon – to dare stating publicly, that Treasuries are not a safe haven investment. This exploding indebtment of the US government – and by the way of its citizens – can only end pretty badly.
    Just to see now on various screen "how encouraging" the spending figures are, whilst peopels income dont rise. Its all on credit again, as usual. One of the links on this page talks of the imminent collapse of the European banking system, which may be right, but if it were to occur, American banks would not be long to follow, because the US consumer is by no means able to repay its credit.
    I am lucky enough not to be Dollar based nor Dollar-zone resident. Thus I would not even touch one of the instruments you are citing to protect oneself. First I do not hold any treasuries, and never will, but second, I would not trust the issuers of those funds ever to pay out a commitment they underwrite. My distrust into the manipulated market goes too far.
    Hopefully though your statements are heard by your fellow citizens and open their eyes on what to expect!

  4. Steve Herbert | August 29, 2011

    Moves by the Swiss to put downward pressure on the Franc have me a bit nervous. With the Rand recently taking a hit, it seems that might be a better choice.

    • Werner | August 29, 2011

      Hello Steve,
      You must realise that the speed of CHF upmove was just too fast to be digested by the local export oriented industry. We are at present coming back to a lesser overvaluation than a fortnight ago. The latest moves by our central bank to inject liquidity and the threat of intervention was made at a very appropriate moment. All charts and technical indicators were overextended, so something had to happen. Dont forget that the US put downward pression on the Dollar since 1971, a time at which a Dollar bought CHF 4.29, we are now back to 0.82 which also happens to be a very important point on Gann's square of 9, if you were a fan of that theory. Its pretty empirical, but it usually works quite nicely.
      As to its relative value to the Euro, that's another point. Reasonable value would be roughly 1.25 CHF for 12 Euro if compared to prices in France, but at least 1.30 if compared to German prices. I dont think the Euro in its present form will be sustainable for very long, but would not put a time frame on it. Note however that the French will go to the polls in May next year and that may deal another game alltogether.

  5. jj | August 29, 2011

    I still continue to see "financial advisors" using this formula of having more bonds as you get older.When are these fools going to give up on this nonsense.The Dollar is the common stock of the U.S. govt.That govt is broke and with millions of boomers retiring,there is no way things can get better.Why anyone would want to hold long term promises of payment in devalued fiat,is beyond me.

  6. Don | August 29, 2011

    I wonder if you would clarify for us the practical distinction between "currency loss" and "inflation". Is it not reasonable to treat gold as a defacto currency and simply leave the purchase of other currencies out of the picture? It seems that each national currency is in one way or another in a race to the bottom. Why do I want to invest in one that's not doing as well for the moment?
    Thanks for your very insightful work.
    Don

  7. DENIS@INTOSALES.COM | August 29, 2011

    Now I've read a report from you guys discussing US dollar going up as Euro instability spirals out of control and this report talks about potential decrease of US dollar by 20%. Which one is it?

  8. Agata Valentina | August 29, 2011

    It was a perfect week for gold to catch its breath. Earthquake, hurricane, and Libya kept us transfixed while Jackson Hole became a sideshow.
    But the steep correction did teach me something about trading gold. You can't do it without technical assistance. You don't want to end up like Hamlet: To be or not to be," "Go long or don't go long? That is the question…"
    Been using this to rock steady – a small, stellar primarily technical analysis company: http://ow.ly/69JZ1

    Be sure to try the free subscription. It actually is free and they don’t bug you. Nothing to lose. I’m just saying, Gary Wagner of the Gold Forecast is shockingly accurate. It is truly uncanny.

  9. billy gatey | August 29, 2011

    treasury yields on the 10 yr are going to 1%
    tbt going down to low teens

  10. Stephen Cooke | August 29, 2011

    Martin is 100% correct that the bond market will collapse and his recommendations are excellent. It is just a matter of timing. Now is not yet the time to buy TBT long. When stocks are falling and bonds are falling at the same time, then that will be a good sign that buying TBT is good.

  11. Ventureshadow | September 5, 2011

    The government controls the interest rate on US treasury debt. They can and do set it as they wish. There is no free market on US treasury debt. Stockholders will not make money on TBT, not in the past, not now, not ever. What the US government can not control is the value of the US dollar. Their manipulations of interest rates on US treasury debt serve to drive down the value of the US dollar.

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