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The Coming Bond Market Crash: The Three Moves Every Investor Must Make

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 yesterday (Thursday), meaning the Fed will no longer be a big buyer of Treasury bonds.

So starting today (Friday), the U.S. Treasury needs to sell twice as many Treasury bonds to end investors as it had been.

But 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.

Let me explain …

A Timetable for the Coming Crash

I'm an old bond-market hand myself – 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.

The bottom line: 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 (ECB) 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. Alas, 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 current U.S. President Barack 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.
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 (ETFs) SPDR Gold Trust (NYSE: GLD) and iShares Silver Trust (NYSE: 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 (CBOE). 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.

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Join the conversation. Click here to jump to comments…

  1. fatima | July 1, 2011

    Can you give some insight as to the real economic situation in Trinidad and Tobago?

  2. Hivno | July 1, 2011

    Great article, Thanks !
    I respect someone who will put it out there and then give direct advice about what to do. What we do with that advice is then up to each individual but this article is definitely worth considering.
    Mentioning the timing is a brave move but at least it's based on market factors, not a guess. It will be interesting to see what transpires.

  3. JohnS | July 1, 2011

    Martin, I can't argue with your logic — it's right on! I'm just not sure of the timing……2011? 2012? 2013?

  4. rick ames | July 1, 2011

    what about the inverse ETF to TLT……….TBT? is that attractive?

  5. Benny Chan | July 1, 2011

    The system has just got to get use to a high bond yield after QE2 and before any QE3 clone. Although QE2 was intended to save main street, it actually bought time for Wall Street to adjust their bond holdings to address the expected post QE2 yield increase. It may hurt the pockets of some bankers but will not cause another financial tsunami. China is also well prepared for the consequences and will continue to buy bonds. No one is stupid enough to puncture the same life bouy. Likewise with a higher bond yield, Japan is more likely to reinvest its treasury holding and print yen instead to finance their national reconstruction. Since the Fed is prepared to reinvest, a lower bond price will buy the Fed more bonds.

    The core inflation is not as threatening, therefore inflation can be capped by corn and oil prices, with clever plays of inventory or production. Inflation is going up but not beyond customer's affordability (as in the case during a real depression). Customers must get back to basic and there are less expensive substitutes. Will the GDP stalls? QE2 did not do any better. If the fund for QE2 went into real production instead of dressing up balance sheets, the GDP would have been positive instead of negative. An orchestrated increase in yield will halt customer wastage and rechannel capitals back to production to generate real jobs. Some belt tightening and sacrifice are necessary by every citizen and more so by the fat bankers in Wall Street!

  6. John Craft | July 2, 2011

    I am almost 80 years old and am holding several large holdings in CD's which will be expiring in
    2012. I'm to old to do any speculating and wondering if and when these CD rates will be going up.

    Thank you,
    J. Craft

  7. Gordan Finch | July 2, 2011

    Bang on centre, property is the future prime investment, the past hype from bankings gangsters is as always fraud.

  8. Raje Hoffman | July 3, 2011

    Thanks for your informative and insightful article. I don't have Option account and I have
    never played option. How do I go about buying the Jan. 2013 CBOE put option on
    Treasury bond futures?

    Any advice would be appreciated. You can send your reply to my e-mail mentioned
    above. I would very much appreciate that.


  9. Alby | July 7, 2011

    Buy TBT or PST… That's the anti-treasury play.

  10. Rob Yankana | July 8, 2011

    Any insight on Rochester Municipals C (RMUCX) would be greatly appreciated, thanks

  11. Ian Shearer | July 19, 2011

    The main article is fine but Gordan and Benny need a re-think.

    Gordan. Property is not exempt from the laws of supply and demand. It cannot go up for long at a rate outstripping the rise in net wages. In USA generally domestic and mainstream commercial property is in oversupply because many of the recent buyers turned out to be men of straw who could not afford the repayments even if they kept their jobs/businesses. There will be pockets of property e.g. A list city centres, where demand exceeds supply and investment there should better inflation, but choose carefully, they are not cheap now.

    Benny. Start from a position where your idea is that China will not wish to see bond prices collapse because it has so many already. However China intends to buy more. The price of the bonds it already has is not a concern to it because it is not a seller. The yield on those is fixed and locked in. However why should it support a market now? The alternative, since it intends to buy more and could pick them up at half price is to sit on its hands until the market tanks!

    Inflation is not going up despite a massive increase in the money supply – but that is temporary. The money is not finding its way into the markets for goods and services because it is going on banks balance sheets at the same rate the value of property/mortgages on those same balance sheets is falling. Should the property market stabilise the banks will hurl that cash (no longer needed as Tier 1 deposits) into the markets chasing a return. Then you will see inflation and the only way Bernake is going to get that money back out of the system is to offer inflation-beating yields on Treasuries say 10% on medium term notes.

  12. The Nervous Cat | May 27, 2012

    Still wating for the bond market crash nearly a year later after your post.

  13. hellhole | October 15, 2012

    ^ It is 2013, QE3 is out so maybe his timing is off but with all the printed money pushed out the bond market collapse scenario is looking much more likely and will be far bigger.

  14. Josh Binary | January 13, 2016

    Well, I have an account in binary options. I can truely say that it is very profitable. I can make 1,500$ a week.

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