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

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. The 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.

News and Related Story Links:

• Money Morning Special Report:
  Inflation Fears: A Sanguine Fed is Underestimating the Escalating Threat.
• Money Morning Special Report:
  S&P Downgrade Shows U.S. Debt Crisis Could Have Dire Consequences.
• Money Morning News Archive:
  QE2.
• Money Morning Investment Research:
  Silver Investing Strategies: The Outlook for the "Other" Precious Metal.
• Money Morning Investment Research:
  Gold Will Continue to Shine Amid Market Uncertainty.
• Money Morning Special Investment Research Report:
  Special Report: How to Buy Silver,
• Money Morning Special Investment Research Report:
  Special Report: How to Buy Gold.
• Money Morning Special Report:
  Special Report: Though it's Called "Junk Silver," the Profits Aren't Trash
• Wikipedia:
  Producer Price Index.
• Money Morning Investment Strategies:
  Investment Strategies For 2011: The Right Way to Use Inverse Funds.