the movement should be fairly limited and could be interpreted as part of the “normalisation” of financial conditions.

From Reuters:

"Felix Salmon

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May 28th, 2009

T-bond one-liner of the day

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Posted by: Felix Salmon

Tags: bonds and loans

The rise in US long-dated Treasury yields summed up in a nutshell, from Fitch’s David Riley: Treasuries were “moving from a risk-free asset to a return-free risk asset”."

"John Kemp

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May 28th, 2009

U.S. benchmark bond sell-off accelerates

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Posted by: John Kemp

Tags: Uncategorized, bond market, risk, united states, yields

Benchmark 10YR US Treasury bonds continued to sell off heavily yesterday, sending yields to the highest level since Nov 2008.

The adjustment in the US Treasuries market is THE story in financial markets, and will wash across all other asset classes.

The key question is how to interpret it:

(1) Is this simply an unwinding of the unsustainable “bubble” that had emerged in US Treasuries during the flight from risk, that is now gradually deflating as risk aversion ebbs. If so, the movement should be fairly limited and could be interpreted as part of the “normalisation” of financial conditions.

(2) Is it the start of a flight away from Treasuries as fears about inflation and record issuance and debt levels trigger a fundamental reassessment — in which case the move could be much larger and far more destabilising.

Either way, this is the single most important story for all asset classes at the moment — with washover into FX as well as equities and commodities."

Me:

“(1) Is this simply an unwinding of the unsustainable “bubble” that had emerged in US Treasuries during the flight from risk, that is now gradually deflating as risk aversion ebbs. If so, the movement should be fairly limited and could be interpreted as part of the “normalisation” of financial conditions.”

My view has been that, for QE to work,especially against Debt-Deflation, you need short term interest rates to stay low, while you need long term interest rates to rise. In terms of incentives, you want to attack the fear and aversion to risk, by having a disincentive to buy short term bonds at no yield, the flight to safety, giving a push towards stocks and corporate bonds, and you want rising long term interest rates, signaling confidence in a recovery, as the spread is widening, and giving an incentive for longer term investing. It seems to be working.

I think that this is the first post that I’ve found that at least posits this position, but I thought that this is what Bernanke was aiming for when he said that he wanted to attack the problem of the fear and aversion to risk. Quite frankly, the longer and shorter term rates moving in tandem doesn’t make sense to me, unless you’re trying to work simply on mortgage rates, which to me is a bad idea.

- Posted by Don the libertarian Democrat Your comment is awaiting moderation.

I’m glad that James Grant was brought up:

http://www.greenlightadvisor.com/documen ts/Grant120408FTcom.pdf

“In their magnum opus Security Analysis Benjamin Graham and David L. Dodd advise that “bonds
should be bought on their ability to withstand depression”. They wrote that in 1934. So far is that
rule from being honoured by today’s financiers that not a few bonds—and boxcars full of
mortgages – could hardly withstand prosperity. Two urgent questions present themselves. One: does
something far worse than recession loom? Two: does that certain something definitely spell much
lower interest rates?
We can’t know, but we can at least observe. What I observe is a monumental push to reflate. The
Federal Reserve is creating more credit in less time than it has ever done before – in the past three
months the sum of its earning assets, known in the trade as Reserve Bank credit, has grown at the
astounding annual rate of 2,922 per cent. Are the bond bulls quite sure that these exertions will raise
no inflationary sweat?
Evidently, they are—at least, forward swap rates betray no such concern. The market’s best guess as
to what the 10‐year Treasury will yield in 10 years’ time is 2.78 per cent, never mind the famous (and
now, as it seems, prophetic) remark of Fed Chairman Ben Bernanke that the Fed could drop dollars
out of a helicopter in a deflationary pinch.
The non‐Treasury departments of the credit markets have crashed. No surprise then that prices and
values are deranged. Market makers have closed up shop for the year, while hedge funds cower in
fear of redemptions. You’d suppose that professional investors – doughty seekers of value – would
be combing through the debris for bargains. Alas, no. Most seem content to lend money to Henry
Paulson (subsequently to Timothy Geithner) at 2 per cent or 3 per cent.”

And:

“Risk‐free return” is the standard tag attached to the government’s solemn obligations. An investor I
know, repulsed by prevailing government yields, has a timelier description – “return‐free risk”.

I think that it’s these investors that we’re trying to tempt.

- Posted by Don the libertarian Democrat

as investors demanded higher yields to lend to the government for longer periods

TO BE NOTED: From Bloomberg:

"Treasuries Little Changed as Fed Readies Purchases of Debt

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By Dakin Campbell and Wes Goodman

April 13 (Bloomberg) -- Treasuries were little changed as the Federal Reserve prepared to buy U.S. government securities today and tomorrow in an effort to cut borrowing costs.

Investors seeking safety during the first global recession since World War II increased holdings of Treasury and agency debt to record levels, a survey of fund managers by Ried, Thunberg & Co. shows. Government and central bank reports this week will show U.S. retail sales rose in March, while a drop in factory production and slower inflation indicate the recession isn’t over, according to surveys of economists by Bloomberg.

“We traded off under the weight of supply last week,” said Martin Mitchell, head of government bond trading at the Baltimore unit of Stifel Nicolaus & Co. “Absent supply, the market will tend to drift lower in yield.”

The yield on the 10-year note rose one basis point to 2.93 percent as of 8:15 a.m. in New York, according to BGCantor Market Data. The price of the 2.75 percent security due February 2019 fell 1/32, or $0.31 per $1,000 face amount, to 98 14/32. U.K. trading of Treasuries was closed today for the Easter holiday, the Securities Industry and Financial Markets Association said.

Fed Buying

Ten-year yields will be in a range of 2.5 percent to 3 percent through the middle of the year, according to Kei Katayama, who oversees $1.6 billion of non-yen debt in Tokyo as leader of the foreign fixed-income group at Daiwa SB Investments Ltd., part of Japan’s second-biggest investment bank. The figure will fall to 2.75 percent by June 30, according to a Bloomberg survey of banks and securities companies with the most recent forecasts given the heaviest weightings. The yield has averaged 4.24 percent for the past five years.

The central bank plans to buy Treasuries due from March 2011 to April 2012 today and from September 2013 to February 2016 tomorrow, according to its Web site. The Fed has more than doubled the size of its balance sheet to $2.09 trillion in the past year by purchasing financial assets including Treasuries in an effort to spur growth.

Investors increased Treasury and agency holdings to 45 percent of their portfolios, matching the all-time high set in October 2002, according to Ried Thunberg, a research company in Jersey City, New Jersey. Agency debt is comprised mostly of securities sold by Fannie Mae and Freddie Mac, the two largest providers of funds for mortgages.

Decline Predicted

U.S. bonds may still fall, the survey showed. An index measuring investors’ outlook for Treasuries through the end of June declined to 43 for the seven days ended April 9 from 44 in the previous week. A reading below 50 means investors expect prices to drop. Ried Thunberg surveyed 25 fund managers controlling $1.35 trillion.

China, the largest holder of U.S. debt outside the nation, should buy more short-maturity U.S. Treasuries than long-term notes, the Oriental Morning Post reported today, citing a former adviser to the People’s Bank of China.

The government should “adjust the maturity structure, and keep asset and currency structures basically unchanged,” Li Yang said in Beijing, the Chinese-language newspaper reported.

Foreign holdings of Treasury bills surged to a record $486.9 billion in January from $207.1 billion a year earlier, according to the Treasury Department. Shorter-maturity bills tend to follow central bank interest rates while bonds are influenced more by inflation.

Yield Curve

The difference between two- and 10-year yields widened to 1.96 percentage points from 1.25 percentage points in December as investors demanded higher yields to lend to the government for longer periods.

Fed purchases have created a Treasury market “bubble” that may keep growing, said Jim Rogers, an investor and author of the book “Hot Commodities.” The Fed, like the Bank of Japan before it, is supporting government debt, he said.

“In Japan, long-term bonds were yielding one half of one percent at one time,” Rogers said on Bloomberg Television in an interview from Singapore, where he lives. “This can go to absurd levels, and bubbles usually do.”

Japan’s 10-year yields, little changed today at 1.46 percent, fell to 0.43 percent in June 2003, the lowest since Bloomberg data tracking the figure began in 1985.

Thirty-year mortgage rates rose to 4.87 percent in the seven days ended April 9 from 4.78 percent the week before, which was the lowest since Freddie Mac, the McLean, Virginia- based mortgage-finance company, began tracking the figure 37 years ago. Rates are 1.97 percentage points more than U.S. 10- year yields, widening from 1.46 percentage points two years ago.

TED Spread

Yields suggest U.S. credit markets haven’t fully recovered after last year’s decline.

The difference between what banks and the Treasury pay to borrow money for three months, the so-called TED spread, narrowed to 95 basis points from 96 basis points on April 10. The spread, which reached 4.64 percentage points in October, was about 36 basis points 24 months ago.

U.S. retail sales rose 0.3 percent in March, according to the median estimate in a Bloomberg News survey before the Commerce Department’s report tomorrow. Industrial production dropped 0.9 percent, the 14th decline in the last 15 months, figures from the Fed on April 15 may show, according to a separate Bloomberg survey.

The Treasury Department has ordered General Motors Corp. to prepare for a bankruptcy filing by June 1, the New York Times reported, raising speculation it will default on its bonds. The report cited people with knowledge of the plans.

Cost of Living

Treasuries fell last week as the government sold $59 billion of notes to help fund President Barack Obama’s spending plans. Government securities dropped 1.2 percent in April, extending a 1.4 percent loss in the first quarter that marked the worst start to a year since 1999, according to Merrill Lynch & Co.’s U.S. Treasury Master Index.

Fed Chairman Ben S. Bernanke’s efforts to spur growth may result in a higher cost of living, said Allan Meltzer, the central bank historian and professor of political economy at Carnegie Mellon University in Pittsburgh.

Inflation “will get higher than it was in the 1970s,” Meltzer said. At the end of that decade, consumer prices rose at a year-over-year rate of 13.3 percent. Rising costs erode the value of the fixed payments from bonds.

The difference between rates on 10-year notes and Treasury Inflation Protected Securities, which reflects the outlook among traders for consumer prices, was little changed at 1.35 percentage points from near zero at the end of 2008. The average for the past five years is 2.25 percentage points.

The U.S. consumer price index probably fell 0.1 percent in March from a year earlier, according to economists surveyed by Bloomberg before the Labor Department report on April 15. In February, the index rose at a year-over-year rate of 0.2 percent."

However if a guarantee scheme were created, Asian savers could be willing to invest directly in capital-hungry US industries.

TO BE NOTED: From the FT:

"Asia is the victim if the bond bubble bursts

By Yu Qiao

Published: March 31 2009 20:00 | Last updated: March 31 2009 20:00

President Barack Obama is set to urge leaders to boost government spending to save the world economy. European Union countries are expected to focus on fixing lax financial regulatory systems. For Asian countries, however, the key agenda issue is the safety of their assets denominated in dollars, as they look ahead to a devalued dollar from rising US sovereign debt.

Most of Mr Obama’s stimulus spending is devoted to social programmes rather than growth promotion, which may exacerbate America’s over-consumption problem and delay sustainable recovery. On top of this, the unprecedented fiscal stimulus, with the Federal Reserve’s move to inject money into credit markets, contains self-destructive seeds. The US risks ending the dollar’s role as the reserve currency, especially considering there is already $10,000bn (€7,535bn, £7,009bn) in US Treasury debt, and much more in liabilities from the costs of social security, healthcare and financial institution bail-outs.

The provision of stable, reliable and viable dollars may be subordinated to short-term US interests, posing a risk to global monetary stability. In the long term, America may seek to resolve its economic mess by devaluing the dollar at best and a default at worst. This is depicted in a Chinese proverb: “Drinking poisonous liquid to quench thirst”. History points to examples such as the collapse of the Bretton Woods system in the early 1970s. It is the foreign holders of US obligations denominated in dollars that would end up paying.

Analysts have warned of the dangers of the US Treasury bond bubble that developed in late 2008. Although insurance against sovereign debt default may reduce credit risk, it is unable to safeguard the real value of dollar-denominated securities. If this bubble burst, east Asians would be victims. Their economies directly hold more than $1,600bn of US sovereign debt, or 25 per cent of the total held by the public. Including direct holdings, Asians may hold half of the outstanding public-owned Treasury bonds. China, by some estimates, directly and indirectly holds more than $1,200bn of US Treasury bonds. If the dollar collapsed, the consequences would devastate Asians’ hard-earned wealth and terminate economic globalisation.

No other international monetary system offers a viable alternative. However, we can make the main reserve currency power more accountable by creating an instrument to help manage the global crisis.

The basic idea is to turn Asian savings, China’s in particular, into real business investments rather than let them be used to support US over-con are vulnerable to any fall in the value of the dollar, equity claims on sound corporations and infrastructure projects are at less risk from a currency default. But Asians do not want to bear the risk of this investment because of market turbulence and a lack of knowledge of cultural, legal and regulatory issues in US businesses. However if a guarantee scheme were created, Asian savers could be willing to invest directly in capital-hungry US industries.

First, Asian countries could negotiate with the US government to create a crisis relief facility. The CRF would be used alongside US federal efforts to stabilise the banking system and to invest in capital-intensive infrastructure projects such as a high-speed railway from Boston to Washington DC.

Second, Asians could pool a proportion of their holdings of Treasury bonds under the CRF umbrella to convert sovereign debt into equity investment. Any CRF funds, earmarked for industrial commitment, would still be owned and managed by their respective countries. In return, Asians would hold minor equity shares that would, like preferred stock, be convertible .

Third, the US government would act as the guarantor, providing a sovereign guarantee scheme to assure the investment principal of the CRF against possible default of targeted companies or projects. Fourth, the Fed would set up a special account with the US government to supply liquidity that the CRF requires to swap sovereign debt into industrial investment in the US.

The CRF would lessen Asians’ concern about implicit default of sovereign debts caused by a collapsing dollar. It would cost little and help the US by channelling funds to business investment. Conventional Keynesian policies – fiscal and monetary expansion on a national basis – cannot solve the problem but will make it worse.

The writer is a professor of economics in the School of Public Policy and Management, Tsinghua University, Beijing"

"the Fed “needs to be careful and be ready to reverse course, especially given all the money that it’s pumped into the system.”

From EconomPic Data:

"Long Bond Drops Most in 22 Years... A Trend or Volatility?

According to Brad Setser (former staff economist at the Treasury and current fellow at the Council of Foreign Relations):

In 2007, my best estimate is that China accounted for $120.3b of the $247.2b increase in the outstanding stock of marketable Treasuries not held by the Fed. China absorbed 49% of the net increase.

In 2008, my best estimate is that China bought $374.6 billion of the $1684.8 billion increase in the outstanding stock of marketable Treasuries not held by the Fed. China absorbed 22.2% of net issuance.

Thus, while China is an extremely important player in the Treasury market, purchasing 3x more Treasuries in 2008 than in 2007, they became a smaller relative player as demand from non-Chinese sources grew astronomically( THE FLIGHT TO SAFETY. WOW. ). So while there has been a media frenzy over Treasury Secretary Geithner's comments regarding Chinese currency manipulation and how China might react, it may be the lesser concern (back to Brad):

Obviously, it would be a big deal if China stopped buying and started selling. But it would be much bigger deal if private investors lost their appetite for Treasuries.

This past week we saw a massive sell off of long-dated Treasuries, supposed proof that this appetite is waning relative to the expected supply. According to Bloomberg:

Treasuries fell, with 30-year bonds losing the most this week in 22 years, as the U.S. readied $78 billion in debt sales over the next five days to finance fiscal stimulus spending projected to swell the deficit to $1 trillion.

While it is important to take note of any movement not seen in 20+ years, one week does not make a trend. In looking at the chart below, which details the historical 'week over week' change in the yield of the thirty year bond (in relative terms as a 30 bp move is obviously more drastic when yields are 2.9% vs. 10.6%), we see just how large an outlier this past week's move was (hint- the top right dot).



However, this chart also details how volatile the long bond has been... far more volatile in 2008-09 than at any other point in recent history and in both directions. The only previous time since 1980 the yield jumped or dropped at a similar magnitude was the week following Black Monday, October 1987. But that 100 bp drop (from ~10.2% to ~9.1%) was in response to a massive liquidity injection by Alan Greenspan following the 22.6% drop in the Dow on that single day.

Thus, while it is important to keep an eye on the long bond to see if the recent sell off does become a trend, please don't declare victory on your long Treasury shorts yet. Just remember, the Fed has another "weapon" available... the outright purchasing of Treasuries which may be on the way..."

From Bloomberg:

By Rich Miller

Jan. 26 (Bloomberg) -- Federal Reserve Chairman Ben S. Bernanke and his colleagues may try once again to cure the aftermath of a bubble in one kind of asset by overheating the market for another.

Fed policy makers meeting tomorrow and the day after are exploring the purchase of longer-dated Treasury securities in an effort to push up their price and bring down their yield. Behind the potential move: a desire to reduce long-term borrowing costs at a time when the Fed can’t lower short-term interest rates any further because they are effectively at zero.

The risk is that central bankers will end up distorting the Treasury market, triggering wild swings in prices( LOOK AT THE CHART ABOVE ) -- and long-term interest rates -- as investors react to what they say and do. “It sets forth a speculative dynamic that is very unstable,” says William Poole, former president of the Federal Reserve Bank of St. Louis and now a senior fellow at the Cato Institute in Washington.

The Treasury market has “some bubble characteristics,” Bill Gross, the manager of Newport Beach, California-based Pacific Investment Management Co.’s $132 billion Total Return Fund, said in December on Bloomberg Television. He echoed that sentiment last week.

“I will say, and I have said for the past three months, the governments are very overvalued,” Gross said in a Jan. 20 interview. Treasuries last year returned 14 percent, according to Merrill Lynch & Co.’s Treasury Master Index, their best performance since 1995.

Inflated Prices

Recent history shows the economic danger of inflating asset prices. After a stock-market bubble burst in 2000, the Fed slashed interest rates to as low as 1 percent and in the process helped inflate the housing market. The collapse of that bubble is what eventually helped drive the U.S. into the current recession, the worst in a generation.

Faced with the danger of a deflationary decline in output, prices and wages, the Fed is considering steps to revive the moribund economy. On the table besides bond purchases: firming up a pledge to keep short-term interest rates low for an extended period and adopting some type of inflation target to underscore the Fed’s determination to avoid deflation.

The central bank has been buying long-term Treasury debt off and on for years as part of its day-to-day management of reserves in the banking system. Yet it has always gone out of its way to avoid influencing prices. What it’s discussing now, says former Fed Governor Laurence Meyer, is deliberately trying to push long rates below where they otherwise might be.( TRUE )

Fed Purchases

Bernanke raised this possibility in a speech on Dec. 1. While he didn’t specify what maturities the Fed might buy, in the past he has suggested that purchases might include securities with three- to six-year terms.

Investors immediately took notice, with the yield on the 10-year note falling to 2.73 percent from 2.92 percent the day before. Yields fell further on Dec. 16, dropping to 2.26 percent from 2.51 percent the previous day, after the central bank’s policy-making Federal Open Market Committee said it was studying the issue.

“Every time they mention it, the market reacts,” says Stephen Stanley, chief economist at RBS Greenwich Capital Markets in Greenwich, Connecticut.

Yields have since risen, with the 10-year note ending last week at 2.62 percent. Behind the reversal: expectations of massive fresh supplies of Treasuries as the government is forced to finance an $825 billion economic-stimulus package and a possible new bank-bailout plan. This week alone, the Treasury is scheduled to auction $135 billion worth of securities.

Jump in Yields

David Rosenberg, chief North American economist for Merrill Lynch in New York, says the jump in yields may prompt the Fed to go ahead with Treasury purchases.

This isn’t the first time Bernanke and the Fed have discussed buying longer-dated securities and ended up roiling the market. Bernanke touted the idea as a tool to fight deflation in speeches in November 2002 and May 2003.

Egged on by his comments -- and later remarks by then-Fed Chairman Alan Greenspan that the central bank needed to build a “firewall” against deflation -- many investors became convinced the central bank was poised to buy bonds. The yield on the 10-year Treasury note fell to 3.11 percent in June 2003 from 3.81 percent at the start of the year.

Traders quickly reversed course as it became clear the Fed had no such intentions, sending the 10-year Treasury yield soaring to 4.6 percent just three months later, on Sept. 2.

‘Miscommunication’

Poole, who was then at the St. Louis Fed, was critical at the time of what he called the central bank’s “miscommunication.” He now sees the Fed making the same mistake with its latest suggestions that it might buy longer- dated securities.

“If they do it, it’s going to be disruptive to the market,” says Poole, who is a contributor to Bloomberg News. “If they don’t do it, it will impair the Fed’s credibility and erode the confidence the market has in the statements that the Fed makes.”

Meyer, now vice chairman of St. Louis-based Macroeconomic Advisers, says the Fed should, and probably will, go ahead with purchases as a way to lower borrowing costs. “The story is stop talking and start buying,” he says.

Still, he notes that not everyone at the Fed is enthusiastic about the idea. One concern: Foreign central banks and sovereign-wealth funds, which are big holders of Treasuries, might cool to buying many more if they believe prices are artificially high.( A GOOD POINT )

Undermine the Dollar

That may undermine the dollar. “There’s no guarantee that international investors would switch to other dollar- denominated debt if flushed from the Treasury market,” says Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey.

Tony Crescenzi, chief bond-market strategist at Miller Tabak & Co. in New York, says foreign investors might also get spooked if they conclude that the Fed is monetizing the government’s debt -- in effect, printing money -- by buying Treasuries.( MAYBE )

Bernanke himself, in his 2003 speech, said monetization of the debt risked faster inflation -- something bond investors, foreign or domestic, wouldn’t like.( TRUE )

Some economists argue the Fed would help the economy more if it bought other types of debt. Even after their recent rise, 10-year Treasury yields are still well below the 4.02 percent level at the start of last year.

Corporate Bonds

Yields on investment-grade corporate bonds, in contrast, stood at 8.24 percent on Jan. 22, the latest date for which information is available, compared with 6.45 percent at the start of 2008, according to data compiled by the Fed.

Hawks at the Fed wouldn’t welcome such purchases. They are already uneasy that some of the central bank’s programs are effectively allocating credit to one part of the economy rather than others. Case in point: the Fed’s ongoing program to buy $500 billion of mortgage-backed securities, which Jeffrey Lacker, president of the Federal Reserve Bank of Richmond, has called “credit policy” rather than monetary policy.

J. Alfred Broaddus Jr., who was Richmond Fed president from 1993 to 2004, says the lesson from the early part of the decade isn’t that the Fed went too far in easing policy to avoid deflation -- it’s that policy makers should have tightened more quickly afterwards and not allowed themselves to be boxed in by their pledge to keep interest rates low for a considerable period.

In the current context, that means buying bonds “is something worth looking at,” he says. Still, the Fed “needs to be careful and be ready to reverse course, especially given all the money that it’s pumped into the system.”

"And that attitude is what is going to define the deflationary years that follow, regardless of what government wants."

From Mish's Global Economic Trend Analysis comes an analysis method I agree with, but I disagree with his conclusions. Still, reading a Human Agency Explanation centered on how people actually feel about economics and society gives me some hope going forward:

"Social Mood Will Define The Future

Boomers have known only inflationary or reflationary conditions for most, if not all of their conscious lives. Here is the pattern: Want, work, borrow, spend, enjoy, and worry about the bills tomorrow, as if tomorrow would never come.

Now tomorrow is dawning, the bills are due, and boomers are now entering end of life with a need to consume what they perceived would be a treasure chest of accumulated wealth that would allow them to sustain their inflationary lifestyles to life's end.

However, that wealth has now vanished in a giant deflationary two-step of collapsing home prices and a collapsing stock market. Note that those are symptoms of deflation not proof of it.( I AGREE )

However, 15 out of 15 things one might expect to see happen during deflation are happening now, as detailed in Humpty Dumpty on Inflation.

Material living standards and associated expectations among even the lower working class and poor in the western nations have been raised to levels that will not likely be maintained during a secular deflationary crisis, let alone permit the lifestyles of the upper working class, professional middle class, and wealthy to remain intact.

Is Deflation A Government Choice?

Most still believe in the Fed's ability to inflate another bubble( I DO ). They are mistaken. Instead I offer a Crash Course For Bernanke.

Greenspan had the wind of consumers' willingness and ability to go deeper in debt at his back. Bernanke has the wind of boomers fearing retirement in the midst of falling home prices and impaired bank balance sheets blowing stiffly in his face. There is no cure for what ails us other than time and price. And with the aforementioned attitude changes, the biggest, most reckless, global credit expansion experiment the world has ever seen is coming to an end. Central banks are powerless to do anything about it( I DON'T AGREE. BERNANKE HAS HARDLY BEGUN ).

I know that in theory a determined government can always produce hyperinflation if it wants, I have heard that story 1000 times. If it was so simple in practice, however, yields would not be at 0%( ZIRP IS A POLITICAL PRECONDITION FOR MORE EFFECTIVE INFLATIONARY MEASURES ). Right now, the important thing to note is that even with massive "stimulus", thus far it's dwarfed by the implosion of credit and the trillions of dollars worth of writedowns and bankruptcies that are coming( AS LONG AS THE CALLING RUN ENDS, WE CAN HANDLE EVERYTHING ELSE. ). Japan tried for years to combat deflation and failed.

Government Bonds A Good Bet

In contrast to the Bottom Callers In Junk, Hugh Hendry( I'M A BIG FAN OF HIS ) from Eclectica told CNBC, Government Bonds Still Best Bet.

The video is quite interesting and I recommend listening to it in entirety. With everyone up in arms over the so-called "bond bubble", Hendry has a much more pragmatic view, quite similar to mine. Here is a partial transcript of points Hendry made.

• When it comes to treasuries I don't care about the next 30 years, I care about the next 30 months.
• The Euro is a flawed mechanism and that spells trouble.
• There is no money on the sidelines( THIS IS WRONG ). We have had one of the most profound periods of wealth destruction in the last 12 month. Billionaires are throwing themselves in front of trains. Sideline cash is a myth( WRONG ).
• Debt of all forms went from a generational low of 110% of GDP in 1974 to 360% of GDP recently. We have supersized everything. In 25 years it will be back at 110% of GDP. That has profound implications on valuations and asset classes. It puts a downward damper on everything.

I agree with Hendry's line of thinking, and even more so with all the bottom callers everywhere else. Would I want to buy treasuries for 30 years? Of course not. But that does not make them a good short either, not right now, and certainly not at 5% when many started. Ten year treasury yields are likely to stay under 5% for a long time to come.

Whether or not one considers treasuries to be in a bubble( I DO ), should depend on a frame of reference. I would rather worry about the next two years than the 28 years that follow. Given that a deflationary environment that might last longer than most think, I see no reason to be shorting treasuries here except for a technical scalp. One could just as easily go long, given the wind is still at the back.

Multi-Generational Pendulum Shift In Attitudes

Most simply do not grasp the once in a multi-generational pendulum shift from risk taking to risk aversion( HERE'S MY BIG DISAGREEMENT ). The credit bubble has burst and we are on the back side of Peak Credit.

As determined as Bernanke is, the best he will be able to do is drag things out for years, making zomibified banks in the process. Those who suggest The US Government Will Not Choose Deflation, simply have it wrong. Attitudes are the key and a secular change in attitudes from consumption to savings is now underway( I AGREE THAT THEY'RE THE KEY, BUT THAT THESE ATTITUDES ARE HELLISHLY HARD TO CHANGE, AND, MORE WORRYINGLY, IF THEY DO OCCUR, THEY ARE ACCOMPANIED BY SOCIAL AND POLITICAL CHANGES AS WELL. AS A BURKEAN, THIS WOULD BE A DISASTER. THANKFULLY, AS CHINA KNOWS ABOUT THESE INGRAINED ATTITUDES, THEY CAN MOVE A BIT FOR A WHILE, BUT THEY WILL ULTIMATELY RETURN TO THEIR NATURAL STATE. WE ARE A SPENDER COUNTRY. WE WILL REMAIN SO, OR OUR SOCIETY AND POLITICAL STRUCTURE WILL UNDERGO MASSIVE CHANGES. THAT'S WHAT TERRIFIES CHINA. ) . And that attitude is what is going to define the deflationary years that follow, regardless of what government wants( I AGREE ).

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
Click Here To Scroll Thru My Recent Post List

"Get out of Treasuries. They are very, very expensive,"

Another Bond Bubble theorist on the Telegraph:

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4. Ambrose Evans-Pritchard

The bond bubble is an accident waiting to happen
The bond vigilantes slumber. As the greatest sovereign bond bubble of all time rolls into 2009, investors are clinging to an implausible assumption that China and Japan will provide enough capital to keep the happy game going for ever.( ACTUALLY, THEY ARE TRYING. )

Ambrose Evans-Pritchard
Last Updated: 12:22PM GMT 12 Jan 2009

Comments 41 | Comment on this article

They are betting too that debt deflation will overwhelm the effects of near-zero interest rates across the G10 and nullify a £2,000bn fiscal blast in the US, China, Japan, Britain, and Europe.

Above all, they are betting that the Federal Reserve chief Ben Bernanke will fail to print enough banknotes to inflate the US money supply, despite his avowed intent to do so.

Yields on 10-year US Treasuries have fallen to 2.4pc – a level that was unseen even in the Great Depression. This is "return-free risk", said bond guru Jim Grant.

It is much the same story across the world. Yields are 1.3pc in Japan, 3.02pc in Germany, 3.13pc in Britain, 3.26pc in Chile, 3.47pc in France, and 5.56pc in Brazil.

"Get out of Treasuries. They are very, very expensive," said Mohamed El-Erian, the investment chief at the Pimco, the world's top bond fund, in a Barron's article last week.

It is lazy to think that China, Japan, the petro-powers and the surplus states of emerging Asia will continue to amass foreign reserves, recycling their treasure into the US and European bond markets.

These countries are themselves bleeding as exports collapse. Most face capital flight. The whole process that fed the bond boom from 2003 to 2008 is now going into reverse.

Woe betide any investor who misjudges the consequences of this strategic shift.

Russia has lost 27pc of its $600bn reserves since August. The oil and metals crash has left the oligarchs prostrate. China's reserves fell $15bn in October. Beijing has begun to fret about an exodus of hot money – disguised as foreign investment in plant. The exchange regulator is muttering about "abnormal" capital flows out of the country.

China's $1,900bn stash of foreign bonds is a by-product of holding down the yuan to boost exports.

This mercantilist ploy is no longer necessary, since the currency is weakening. Beijing needs the money at home in any case to prop up the Chinese economy – now in trouble. Even Japan has slipped into trade deficit.

Clearly, the US and European governments cannot rely on Asia to plug the $3,500bn hole in their budgets this year.

Asians are just as likely to be net sellers of their bonds. Which implies that central banks may have to "monetize" our deficits.( TRUE )

James Montier, from Société Générale, has examined US bonds back to 1798. Yields have never been this low before, except under war controls in the 1940s when the price was set by dictate.

That episode is not a happy precedent. The Fed drove the 10-year bond down to 2.25pc, much as it is doing today with mortgage bonds. It helped America win World War Two, but ended in tears for bond holders in 1946 when inflation jumped to 18pc.

Mr Montier said yields have averaged 4.5pc over two centuries, with a real return of around 2pc. By that benchmark, the market is now banking on a decade of deflation.

Investors have drawn a false parallel with Japan's Lost Decade, when bond yields kept falling, forgetting that Tokyo waited seven years before resorting to the printing press. Mr Bernanke has no such inhibitions. He has hit the nuclear button in advance.( I AGREE )

"Today's yields are woefully short of the estimated fair value under normal conditions. There maybe a (short-term) speculative case for buying bonds. However, I am an investor, not a speculator," he said( I POSTED ON THIS )

Of course, we may already be so deep into debt deflation that bonds will rally regardless( TRUE ). Fresh data suggest that Japan's economy contracted at a 12pc annual rate in the fourth quarter of 2008; the US, Germany, and France shrank at a 6pc rate, and Britain shrank at 5pc.

If sustained, these figures are worse than 1930, though not as bad as the killer year of 1931. The UK contraction from peak to trough in the Slump was 5pc. Gordon Brown will be lucky to get off so lightly.

The Fed's December minutes reek of fear. The Bernanke team is no longer sure that stimulus will gain traction in time.

The Fed's "Monetary Multiplier" has collapsed, falling below 1. This is unthinkable. We are in a liquidity trap.

So yes, printing money is not as easy as it looks, but to conclude that the Fed cannot bring about inflation is a leap too far.( I AGREE )

The Fed has only just started to debauch in earnest, buying $600bn of mortgage bonds to force home loans down to 4.5pc. US mortgage rates have dropped 150 basis points in two months.

My tentative guess is that Bernanke's blitz will "work" – perhaps later this year. Markets will start to look beyond deflation. They will remember that the Fed is boosting its balance sheet from $800bn to $3,000bn, and that it sits on an overhang of bonds that must be sold again.

"The euthanasia of the rentier" will wear off, to borrow from Keynes. That is when the next crisis begins."

Sad to say, that's how I see it.

"Longer Treasury bonds are the better bubble candidates. "

From Accrued Interest:

"2009 Forecast Episode II: Deflation Strikes Back

This is Part II of a indeterminate series on the Accrued Interest 2009 Forecast. Here I'll focus on general interest rates and Treasury Bonds.


The question on many lips is are Treasury bonds a bubble? I've already said that fighting deflation will be the major theme of 2009. Deflation will remain the primary concern of the Fed until housing prices start to recover. I don't see that happening until 2010( I DISAGREE ). Until housing prices start to rise, we'll see persistently poor final consumer demand( I DISAGREE ). This in turn keeps the velocity of money low and thus the money supply contracting.


I have a very simplistic mental model for Treasury rates. Real interest rates should reflect the opportunity cost of money. Thus a short-term Treasury rate should be the opportunity cost plus an inflation premium. Longer-term rates should reflect both opportunity cost, inflation, and a term premium. When economic growth is weak, opportunities are less, and thus interest rates should fall.


If we have negative inflation, then short-term Treasury rates should be extremely low. Near zero makes sense for T-Bills (although negative yields is questionable at best). Less than 1% makes sense for the 2-year. So I see no bubble on the front end of the Treasury curve. Not that there is a ton of upside on the 2-year at 0.75%, but could it go to 0.50%? Sure.


Longer Treasury bonds are the better bubble candidates. One might be able to argue that in the short term, both growth and inflation will be negative, thus the equilibrium nominal short-term rate should probably be negative. But longer term, we'll eventually have both growth and inflation, and thus long-term Treasuries should not be approaching Japanese-like levels( I AGREE ).

So when the 10-year was pushing 2%, it felt bubbly. But still I resist the bubble label. To me, Treasury rates are clearly below "fair value" but given the extreme liquidity and economic circumstances, I doubt the 10-year can move above 3% until at least 4Q 2009. I think long-term Treasuries remain over-valued until its obvious that inflation is going to eventually become a problem.( A FAIR POINT. I BELIEVE PEOPLE WILL PULL OUT BEFORE THAT. )

What about Treasury supply you ask? Won't the massive debt load eventually push rates much higher? While acknowledging that supply is an obvious negative for prices always and everywhere, as it is, Treasury supply is clearly not overwhelming demand. The 3-year and 10-year auctions from last week went quite well.

Besides the theory that government debt crowds out private investment doesn't hold water right now. Private lending ain't happening in areas where the government isn't subsidizing. In essence, the Treasury is leveraging because the private sector can't.( TRUE. MULLIGAN DOESN'T SEE IT. )

Eventually, the Fed's programs will result in much higher inflation, and thus Treasury rates will rise substantially( I AGREE ). But I think this is a year or more away, too far away to recommend a short.

The problem for real money investors is that Treasury yields are so low, that you pretty much have to own something else. The yield advantage on short-term Agencies versus short-term Treasuries is so large that there isn't any logical scenario where the Treasury outperforms. Therefore I'm playing this by remaining underweight Treasury bonds, but owning stuff that can appreciate if Treasury rates fall. This includes bullet agencies, and some very high quality corporates( THESE MAKE SENSE. )."

He could well be right. I don't want to see another bubble burst, even in my bathtub.

"Of course, having entered into this arrangement, China is hard-pressed to get out of it."

A good post on Bloomberg:

"Jan. 9 (Bloomberg) -- Beijing bookstores would be wise to stock up on Johann Wolfgang von Goethe. His work will help Chinese officials understand the “Faustian bargain” in which they are engaged with the U.S.( IS THE DEVIL INVOLVED? )

The reference here is to a compromise of principles for fleeting gains. In literature, Goethe’s Faust is a mythic German alchemist who made a deal with the devil. And that, in a nutshell, is where China, the biggest foreign holder of U.S. debt, finds itself as America re-inflates its economy.

Treasury Secretary Henry Paulson isn’t the devil, yet on his watch the U.S. has morphed into a huge debt-issuing machine. The Congressional Budget Office says the U.S. deficit will more than double this year to at least $1.18 trillion, the biggest since World War II.

Barack Obama has even bigger plans. The CBO’s estimates don’t include the cost of the president-elect’s stimulus package, which will probably add at least $750 billion to the total over the next two years. Last year’s shortfall totaled $455 billion. The U.S. needs China’s money more than ever.

“I spent most of the first two quarters of 2008 marveling at the pace of Chinese reserve accumulation,” Council on Foreign Relations economist Brad Setser in New York wrote on his Web log this week. “I expect to spend the first few quarters of 2009 marveling at the size of the U.S. fiscal deficit.”

Best Customer

All that borrowing could burst what Bill Gross, co-chief investment officer of Newport Beach, California-based Pacific Investment Management Co., calls a market with “some bubble characteristics.” That isn’t escaping officials in Beijing.( I AGREE )

China owns $653 billion of Treasuries, and indications are that it’s losing its appetite for U.S. debt. Expect Asia’s second-biggest economy to cut the share of dollars in its $1.9 trillion of reserves, and perhaps sharply.( WE'LL SEE )

The U.S. is, after all, acting at the expense of its best customer. Just as shareholders abhor companies diluting their stock with new offerings, China’s debt managers can’t be happy with the Treasury’s plans.( THEY ARE THE ONES WHO MOVED OUT OF AGENCIES INTO TREASURIES IN THE FLIGHT TO SAFETY. )

Along with its Faustian bargain, one wonders if China risks a Madoffian one, too.

No, the Treasury isn’t engaged in a massive fraud of the kind allegedly perpetrated by financier Bernard Madoff. Yet the U.S.’s $5.3 trillion government debt arena is looking more like a Ponzi scheme than a market.

Madoff’s Scheme

Madoff personifies the greed, lack of transparency and lost trust that has accompanied the U.S.’s fall from grace. Even though skeptics raised concerns about the veracity of Madoff’s performance over the years, regulators failed to act. They believed Madoff’s assertions and figures.

The reason credit-rating companies aren’t swarming around and threatening to downgrade the U.S. is trust. It’s a deep belief that the issuer of the reserve currency and one without foreign-currency debt will always make its payments. That doesn’t mean critics who say the market has become the world’s biggest pyramid scheme are wrong.

Holding the whole thing together is the idea that there will always be fresh money flowing in to save investors already there. A pyramid-scheme dynamic is very much at play. Treasury holders won’t lose everything the way Madoff’s investors might. Yet China will suffer when foreigners sell Treasuries and yields surge.( TRUE. BUT IT'S A PRICE THAT THEY WILL PAY BECAUSE THEY WANT OUR ECONOMY TO GET GOING AGAIN. )

Sucker’s Bet

The question is how aggressively China will shield itself from what increasingly looks like a sucker’s bet. Economists at Deutsche Bank AG in Frankfurt, for example, estimate China will trim the share of dollars to about 45 percent this year from more than 70 percent in 2003.( WE'LL SEE )

Of course, having entered into this arrangement, China is hard-pressed to get out of it. Its economy is largely about selling manufactured goods overseas.( THAT'S IT. THE SAVER/EXPORT COUNTRIES WANT THE SAVER COUNTRY/SPENDER COUNTRY SYMBIOSIS TO CONTINUE IF AT ALL POSSIBLE. )

“I am not suggesting this model is irrevocable,” says David Gilmore, partner at Foreign Exchange Analytics in Essex, Connecticut. “Like anything in economics, situations evolve. But in the midst of a global slowdown the world has not seen since World War II, now is not the time for China to throw out the existing economic model for a new one.”( THEY DON'T WANT TO )

Relying on domestic demand is a long-term goal that will require deft policy making and a high level of tolerance for disruptions in the short run. It’s not clear 2009 is the year to make that transition.

The best scenario for China is for American consumers to resume buying its goods. China has a vested interest in not doing anything to complicate things for the biggest economy. Pulling the plug on Treasuries would make headlines, precipitate a run on the dollar and hurt U.S. growth( THAT'S MY POSITION ).

That doesn’t mean China wants to risk more money on a Ponzi scheme in its last throes. The world is littered with examples of how that can turn out. And China’s 1.3 billion people could sure use some of that cash back home as their own economy falters.

(William Pesek is a Bloomberg News columnist. The opinions expressed are his own.)"

As I've said, China will do all that it can to preserve the current Saver Country/Spender Country symbiosis. I wouldn't put allowing some US default on their part past them. Think of the Treasury Bonds Bubble as a form of allowing the US to default on some of its debt.

"Bernanke is making a time-inconsistent promise to hold interest rates low for an extended period."

From Alphaville:

"Battle of the bears Posted by Neil Hume on Jan 06 16:20. Comment.

“

“An investment operation is one which, upon through analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.””

That’s a quote from legendary value investor Benjamin Graham and it features prominently in James Montier’s first strategy piece of 2009. More…

“An investment operation is one which, upon through analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative( I AGREE ).””

That’s a quote from legendary value investor Benjamin Graham and it features prominently in James Montier’s first strategy piece of 2009.

Titled “Bonds - speculation not investment”, the SocGen strategist reveals he has fallen out with colleague and uber bear Albert Edwards for the first time in eight years.

The reason for the row is, as you might have guessed, about the current state of the government bond market.

From my perspective as a long-term value-orientated investor, bonds simply don’t offer any value. They already price in the US slipping into Japanese-style prolonged deflation. However, they offer no protection at all if (and it may be a big if) the Fed can succeed in reintroducing inflation (what Keynes described as the “euthanasia of the rentier”). There may be a ‘speculative’ case for continuing to hold bonds, but there isn’t an investment case.( I AGREE )

To my mind, in principle, government bond valuation is relatively simple. I see the value as the summation of three components: the real yield, expected inflation, and an inflation risk premium. The market tells us the real yield for ten-year US government bonds is around 2%. Given that the nominal yield is also around 2% at the moment, the market is implying that inflation will be around 0% p.a. over the next ten years.( SILLY )

As regular readers will know Mr Edwards thinks differently. This from his final note of 2008.

John Kemp, a Reuters columnist wrote an interesting article yesterday entitled “Fed unleashes greatest bubble of all”. He stated, “Bernanke is making a time-inconsistent promise( THIS MIGHT BE WHY HE'S NOT CALLING HIS POLICY QUANTITATIVE EASING, WHICH WOULD DEFINITELY BE A TIME-INCONSISTENT PROMISE, AND SO HE'S AVOIDED THAT BY NOT TARGETING AN INFLATION RATE, HOPING TO KEEP THEM DOWN. IT'S ALSO A WAY TO GIVE A SIGNAL TO INVESTORS THAT INFLATION COULD BE AHEAD, WITHOUT CAUSING A PANIC TO SELL TREASURIES. ) to hold interest rates low for an extended period.” For if the policy is successful, investors buying bonds at current levels will incur “massive losses”.( TRUE ) I have been debating this very subject with my colleague James Montier recently. After all how much lower can bond yields go (see chart below)? But for now I retain my bias towards government bonds. Investors, I believe, underestimate how very close the global economy is to getting trapped in outright deflation( COULD BE ). We expect panic( I DON'T ) to grip the markets at some point in the first half of next year, sending both equity prices and bond yields substantially lower.( THAT'S WHAT COULD HAPPEN )

In fact, Montier says the divide between himself and Edwards is not as wide as it first might seem. He says both men could be right just at different times.
I tend to view the world through the lens of a long-term valueorientated absolute-return investor. Albert is often more willing to tolerate momentum driven shorter term positions (believe it or not!). Perhaps it is these differences in approach that have lead to us to adopt different positions on the merits of holding government bonds.

Of course, there maybe a speculative case for buying bonds. If the market is myopic (which is almost always is) then poor short-term economic data, and the arrival of outright deflation could easily see yields dragged even lower. Thus riding the news flow may be a perfectly sensible but nonetheless ‘speculative’ approach. However, I am an investor not a speculator (as I have proved myself to be appalling at the latter), thus government bonds have no place in my portfolio.

So what happens next? Montier says he does not have a clue. But he does have a nice a pay off line.

If the alternative scenario comes to pass and the Fed successfully reintroduces inflation (leading to what Keynes so vividly described as the ‘euthanasia of the rentier’2) then bonds look distinctly poor value, thus the risk is exceptionally high and skewed in one direction. As Jim Grant so elegantly put it government bonds may well end up being “return free risk” (as opposed to their more normal nomenclature of risk-free return). If yields were to rise from 2% to 4.5% investors would stand to suffer a capital loss of nearly 20%.

Return-free risk - marvelous!"

# This means that monetary authorities will not be able to reflate the U.S. economy. # As a result, interest rates in the U.S. will fall –not rise

EconomPic Data on a Treasury Bubble:

"Are Treasuries Really in a Bubble?

A Barron's video posted at The Big Picture warns to 'Stay Away From Treasury Bonds'. I'll agree that Treasury bonds look awfully rich and I have no intention of going long, but I do feel there is danger to outright shorting treasuries in this environment (though as I post this, 30 year yields have blown out 20 bps today). First lets look at some data that shows at a minimum long bonds (i.e. 30 year Treasuries) appear rich.

30 year treasury yields have rallied dramatically over the past 25+ years, but the most recent rally is unprecedented over that time.



In terms of pricing, long bonds have rallied more than 30% in the past 3 months. Supporting the case that these bonds are ready to sell off... long bond prices have historically sold off ("mean reverted") following smaller, yet similar rallies.



However, it is important to remember that the current market is not "normal" and mean reversion is not a certainty. Off the top of my head, I can think of many reasons why long bond yields may not only stay at current levels, but may actually continue to rally.

1. Real yields are not abnormally low (a deflationary environment makes those puny yields much better in real rather than nominal terms) ( TRUE )
   
2. The Fed can (and will likely be) purchasing Treasury bonds to keep rates artificially low; likely starting in the 5-7 year space, but possibly out along the curve ( TRUE )
   
3. The economy can continue to get worse / companies will default in the coming year at substantial levels, creating the possibility of another "flight to quality"( TRUE )
   

As Larry MacDonald states in his post Shorting The Bond Bubble? Hold On:

Shorting government bonds would thus appear to be a no brainer as risk appetite responds to signs of an upturn in economic growth and inflation worries arise anew. But what might not be so obvious is the timing of the trade.( A GOOD POINT )

Lags in the impact of stimulus measures could mean deflationary news will linger for awhile yet. More importantly, the Federal Reserve has stated it is committed to buying Treasuries to keep interest rates low until the crisis and economy stabilizes. China too will likely be a buyer of U.S. Treasuries as part of its strategy of suppressing the yuan to enhance the competitiveness of its exports.

So watching from the sidelines may be the strategy for now.

Update: My post was all set to go when I saw Credit Writedowns had an eerily similar post. Always nice to be in good company. "

Now, Credit Writedowns:

"The consensus is coming down on the bearish side for U.S. government bonds in 2009. There is ample reason to believe that Treasuries will be an asset class to avoid this year.

Yet, as I argue in a post a few days ago, “rates can go to unusually low levels for much longer than people think,” as Stephen Roach has said. And with the global economy in a serious state of unwind maybe treasuries are not going to tank. Does this mean, one should be loading up on U.S. Government debt? Not if you believe Andrew Barry of Barron’s Magazine.

The biggest investment bubble today may involve one of the safest asset classes: U.S. Treasuries. Yields have plunged to some of the lowest levels since the 1940s as investors, fearful of a sustained global economic downturn and potential deflation, have rushed to purchase government-issued debt.

The market also has been supported by comments from the Federal Reserve that it, too, may buy long-term Treasuries. - As a result, the benchmark 10-year Treasury note yields just 2.40%, down from 3.85% as recently as mid-November. The 30-year T-bond stands at 2.82%, and three-month Treasury bills were sold last week for a yield of just 0.05%. - Many investors argue it’s dangerous to buy Treasuries with such low yields. While a holder can expect to get repaid in

full at maturity, the price of longer-term Treasuries could fall sharply in the interim if yields rise. The 30-year T-bond, for instance, would drop 25% in price if its yield rose to 4.35%, where it stood as recently as Nov. 13. The bear market may have begun Wednesday, when prices of 30-year Treasuries fell 3%. They lost another 3% Friday. - “Get out of Treasuries. They are very, very expensive,” Mohamed El-Erian, chief investment officer of Pacific Investment Management Co., warned recently. Pimco runs the country’s largest bond fund, Pimco Total Return (ticker: PTTPX). - Treasuries offer little or no margin of safety if the economy unexpectedly strengthens in 2009, or the dollar weakens significantly, or inflation shows signs of reaccelerating. Yields on 30-year Treasuries easily could top 4% by year end.

My personal take on things is the following:

1. The global economy is very weak - much weaker than most people realize ( I DISAGREE )
   
2. This means that monetary authorities will not be able to reflate the U.S. economy. ( I DISAGREE )
   
3. As a result, interest rates in the U.S. will fall –not rise ( I DISAGREE )
   

For what it’s worth, I expect the same scenario to play out in the U.K. as well. Does that mean I m loading up on Treasuries? Not on your life. This is an asset class to avoid. Sometimes the best trade is no trade. If you want U.S. government exposure, TIPS are a hedge against reflation that may be the better trade."

I'll base his opinion on where he puts his money. Actually, both of these posts make good points, and I was beginning to worry since too many people were starting to see the bubble. I feel better being in the minority.

"THE BIGGEST INVESTMENT BUBBLE TODAY may involve one of the safest asset classes: U.S. Treasuries. "

From Barron's, another Treasury Bubble believer:

Get Out Now!

By ANDREW BARY

The bubble in Treasuries looks ready to pop, sending prices on government debt sharply lower. But just about every other corner of the bond market beckons -- and could provide competitive returns with stocks, even if the equity markets have a strong 2009( I AGREE ). (Video)

THE BIGGEST INVESTMENT BUBBLE TODAY may involve one of the safest asset classes: U.S. Treasuries. Yields have plunged to some of the lowest levels since the 1940s as investors, fearful of a sustained global economic downturn and potential deflation, have rushed to purchase government-issued debt.( BECAUSE IT'S GUARANTEED AND EASY TO PRICE AND SELL )

Getty Images

The market also has been supported by comments from the Federal Reserve that it, too, may buy long-term Treasuries. - As a result, the benchmark 10-year Treasury note yields just 2.40%, down from 3.85% as recently as mid-November. The 30-year T-bond stands at 2.82%, and three-month Treasury bills were sold last week for a yield of just 0.05%. - Many investors argue it's dangerous to buy Treasuries with such low yields. While a holder can expect to get repaid in

full at maturity, the price of longer-term Treasuries could fall sharply in the interim if yields rise. The 30-year T-bond, for instance, would drop 25% in price if its yield rose to 4.35%, where it stood as recently as Nov. 13. The bear market may have begun Wednesday, when prices of 30-year Treasuries fell 3%. They lost another 3% Friday. - "Get out of Treasuries. They are very, very expensive," Mohamed El-Erian, chief investment officer of Pacific Investment Management Co., warned recently. Pimco runs the country's largest bond fund, Pimco Total Return (ticker: PTTPX). - Treasuries offer little or no margin of safety if the economy unexpectedly strengthens in 2009, or the dollar weakens significantly, or inflation shows signs of reaccelerating. Yields on 30-year Treasuries easily could top 4% by year end.

The chief risk to the Treasury market stems from the potentially inflationary impact of both the Federal Reserve's super-accommodative monetary policy, which has dropped short rates close to zero, and the enormous looming fiscal stimulus from the federal government( CORRECT ). It also may take higher yields to attract investors -- particularly foreigners -- as the Treasury seeks to fund an estimated deficit of $1 trillion or more in the coming year.( TRUE )

ONE SIGN OF TROUBLE FOR TREASURIES is the resilient price of gold, which has risen $150 an ounce since late October, to $880 an ounce, despite weakness in most commodity prices. Investors rightly see gold as an appealing alternative to low-yielding Treasuries and virtually nonexistent yields on short-term debt as the government cranks up its printing presses. Gold was up $45 an ounce last year, while oil was down 50%. Another worrisome indicator: The dollar has weakened recently, losing 10% of its value against the euro in the past month.

It is difficult for individuals to sell Treasuries short, but two exchange-traded funds, the Ultrashort Lehman 20+Year Treasury Proshares (TBT) and the smaller Ultrashort Lehman 7-10 Year Treasury Proshares (PST), offer a bearish bet on the Treasury market. Both these securities are designed to move at twice the inverse of the daily price movement in Treasury notes and bonds. Since the summer, the 20+Year Proshares has fallen almost 50% as Treasury prices have surged. If Treasury yields return to June levels, the ETF could double in price. Another alternative for T-bond bears is to sell short the iShares Barclays 20+Year Treasury Bond Fund (TLT), an ETF that gives exposure to the long-term government-bond market.

While Treasuries look rich, other parts of the bond market beckon, including municipals, corporate bonds, convertible securities, some mortgage securities and preferred stock. The average junk bond now yields 20%, compared with 9% at the start of 2008.( I AGREE )

Triple-A-rated munis with 30-year maturities are yielding about 5.25%, almost double the yield on 30-year Treasuries. The yield differential between the two markets is unprecedented. Until this year, munis almost always yielded less than Treasuries because of their tax benefits.( LESS GUARANTEED )

Long-term corporate bonds with investment-grade ratings of triple-B now yield an average of 8%, nearly 5.5 percentage points more than Treasuries of comparable maturity. They rarely have yielded more than four points above government debt. Preferred stock of financial companies such as Bank of America (BAC) and Morgan Stanley (MS) yields 9% or more, and many preferreds carry tax advantages because their dividends, like those on common shares, are subject to a 15% federal tax rather than rates on ordinary income.

"The only part of the bond market that you need to be bearish on is Treasuries," says Jim Paulsen, chief investment strategist at Wells Capital Management in Minneapolis. "The other sectors are attractively priced."

A bearish stance toward Treasuries and a bullish one toward the rest of the bond market represents the consensus view. Most equity and bond analysts surveyed last month by Barron's projected the Treasury 10-year note would carry a yield of 3% or higher by the end of 2009 ("Out With the Old," Dec. 22). At the same time, it's hard to find bears on corporate bonds. It's nice to be contrary. Sometimes, however, the consensus view is right.

Lately corporate and municipal bonds have rallied, with Merrill Lynch's junk-bond index gaining more than 6% in December, the strongest monthly increase since 1991. Most yield disparities between corporate and municipal bonds and Treasuries still are off the charts relative to historical ranges. Perhaps more important, absolute yields on corporate and municipal debt look attractive relative to inflation, and even stocks.

It's tough to estimate the current price/earnings ratio on the Standard & Poor's 500 stock index because the profit outlook is so uncertain amid a recession. Assume $60 in S&P earnings for 2009 and the index, now about 925, trades for 15 times forward profits, not cheap by historical standards. Equity bulls are betting the $60 estimate proves conservative, and that corporate earnings grow sharply in 2010. The S&P likely earned about $72 in 2008, before massive write-offs.

The smart money is crowding into the corporate-bond market, including investment-grade debt, junk bonds and so-called leveraged loans, which are bank loans to debt-laden companies such as Neiman Marcus, Georgia-Pacific and First Data. Leveraged loans, which are senior to junk bonds, now trade for an average of about 70 cents on the dollar and carry yield to maturities of 10% to 15%. Many equity-oriented hedge funds and mutual funds have added to their corporate-bond holdings because of enticing yields.( I WOULD )

"The argument is that the credit markets have to straighten themselves out before stocks rebound," says Marty Fridson, who heads Fridson Investment Advisors in New York. "Investors will rotate into the credit markets and then into stocks when they look more promising."

Some investors argue the credit markets are discounting a grimmer economic and financial outlook than the stock market, and thus more opportunity lies in bonds.

THERE CLEARLY IS RISK IN corporate bonds. Junk-bond default rates, which ran at just 3.4% in the past 12 months, are certain to spike in 2009. Moody's Investors Service expects the U.S. junk-default rate to top 10% in the next year.

Yet, with a 20% average yield, junk bonds could provide nice returns, even in that scenario. "You're buying the market at a pretty steep discount," Fridson says. "You're getting compensated for a severe escalation in defaults."

The average junk issue trades for less than 60 cents on the dollar, and some bonds, like those issued by the bankrupt Tribune, have sunk to just pennies on the dollar. Defaults might have to run at a cumulative 50% rate in the next five years and recovery rates average just 30 cents on the dollar -- versus a historical average of about 40 cents -- for investors to get sub-par returns. The junk market declined about 27% in 2008, by far the worst showing in the past 20 years. If history is any guide, 2009 should be better because down years like 1990 often have been followed by big gains. It wouldn't take a lot for junk to return 20% in 2009, given the elevated yields throughout the market.

There are plenty of ways to play the junk sector, including ETFs like the iShares iBoxx $ High-Yield (HYG), open-end funds like Fidelity Capital and Income (FAGIX) and many closed-end funds, including some that trade at double-digit discounts to their net asset value. A complete list of closed-end funds starts on page M45. The Loomis Sayles Bond fund (LSBRX), which owns a mix of U.S. and foreign government bonds, investment-grade corporates and junk debt, fell 22% last year. The fund, co-managed by bond veteran Dan Fuss, now has a current yield of around 11%.

Convertible securities, which were bashed in 2008 in part from forced selling by leveraged hedge funds, offer a nice combination of yield and equity kickers. Issuers include Citigroup (C), Chesapeake Energy (CHK), Vornado Realty Trust (VNO) and Transocean (RIG). Ford Motor 's 4.25% convertible bond due in 2036, trading for about 27 cents on the dollar for a 27% yield to an optional redemption date in 2016, is a good alternative to the common stock (F), which yields nothing.

Vanguard, Fidelity and Putnam all have open-end convertible mutual funds, and there are many closed-end funds, including some trading at discounts to their net asset values.

The backdrop for municipal bonds is troubled because state and local governments are getting squeezed by lower tax revenue and sizable outlays for basic services and other needs. Investors are getting compensation via 5% to 6% yields on top-grade long-term securities and high single-digit to low-double-digit yields on Baa-rated bonds from a range of issuers, including hospitals and state-issued tobacco-revenue debt. Risk-averse investors should stick with state general-obligation bonds or essential-service revenue bonds, which rarely default.

The giant Vanguard Intermediate Tax-Exempt fund (VWITX) was unchanged in 2008, while many long-term funds were down 5% to 10%. There are numerous closed-end muni funds trading at double-digit percentage discounts to their NAVs. Closed-end funds carry more risk because of financial leverage. Their yields generally top 6%.

Low-grade munis were bashed in 2008, and no big fund was harder hit than the Oppenheimer Rochester National Municipals (ORNAX), which specializes in riskier securities. It fell almost 50% on the year, two to three times more than other large funds focused on high-yielding munis. It now carries a tempting current yield of 13%.

While the mortgage market was the root of much of Wall Street's troubles in '08, the country's largest mortgage fund, the Vanguard GNMA (VFIIX), turned in a good year, rising about 7%, by sticking with government-guaranteed Ginnie Maes and avoiding riskier investments.

The problem with Ginnie Maes now is that yields have fallen to about 4%, which will make it tough for investors to generate decent returns barring further rate declines. The better opportunities probably lie in riskier mortgage securities that lack a government backing, including battered issues secured by subprime loans and so-called Alt-A loans, which are a notch above subprime. This area is a minefield, and difficult to play directly. It is probably best to stick with a mutual fund like the TCW Total Return Fund (TGMNX), a mortgage fund run by long-time specialists Jeff Gundlach and Phil Barach. About half its assets are in securities that lack Ginnie Mae, Freddie Mac or Fannie Mae backing. It was up about 1% last year.

For those seeking the safety of Treasuries, the best bet probably is TIPS, or Treasury Inflation Protected Securities. They provide much better yields than ordinary Treasuries unless inflation disappears.

The 10-year TIPS yield 2.23%, versus 2.40% for the regular 10-year Treasury. The so-called breakeven annual inflation rate that would result in similar yields on the two securities is just 0.17% annually (2.40% minus 2.23%), versus a typical spread of more than two percentage points.

TIPS offer a nominal yield, plus principal indexed to inflation. If inflation is 3% annually in the next 10 years, in line with the historical average, TIPS will return 5.25% (the 2.25% nominal yield plus 3% for the inflation component). There are several ways to invest in TIPS, including through open-end mutual funds such as the Vanguard Inflation-Protected Securities fund (VIPSX), and an ETF, the iShares Barclays US Treasury Inflation Protected Securities Fund (TIP).

Despite the risks in government bonds, there is a case for the sector. David Rosenberg, the Merrill Lynch economist who correctly called the housing bubble and resulting economic downturn, wrote in a recent client note titled "The Frugal Future" that the current recession resembles the vicious downturns prior to World War II more than the mild downturns since. The credit crisis and what Rosenberg calls "imploding" household net worth in the U.S. are apt to make it linger through 2009, when the economy could contract 3% in real terms, and perhaps into 2010.

Rosenberg thinks the yield on the 10-year Treasury note might bottom at 1.5%. "Sustained negative wealth effects from the slide in housing and equity prices will reinforce the uptrend in the personal saving rate, creating a highly deflationary environment as job losses mount and push the unemployment rate up toward 8.5% in the coming year," he wrote.( I DON'T AGREE )

It may take such a grim scenario to support Treasuries, given their lofty prices and super-low yields. More likely, the combination of U.S. fiscal and monetary stimulus lifts the U.S. out of recession by the second half of next year and the global economy expands in 2009, albeit at a slower pace than in 2008. Morgan Stanley economists see global growth of 0.9% in 2009, boosted by 3% growth in the developing world. If the more bullish economic and financial scenarios come to pass, interest rates -- and Treasury yields -- likely will rise.

In any event, the Treasury would do well to take advantage of today's rock-bottom yields and significantly increase the issuance of 30-year bonds. One reason the 30-year yields so little is scarcity value.

Of the $874 billion of Treasury notes and bonds issued in 2008, just $35 billion was 30-year debt, according to analysts at Wrightson ICAP in New York. Given its huge borrowing needs, the government arguably ought to issue at least $100 billion of 30-year debt this year and perhaps as much as $200 billion. Treasury bills cost the government next to nothing now, and for better or worse, near-zero rates almost certainly won't last. ( A GOOD IDEA )

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A very sensible post.