Advance warning: Danger of bond market collapse!

If you think 2010 is going to bring investors a carefree, nonstop ride to glory, think again!

Profit opportunities abound, and we intend to be among the first to lead you to them.

But we’re also here to give you advance warnings of threats that can sneak up from behind and catch you by surprise.

Case in point: The danger that Treasury bonds will fall sharply in price, drive up long-term interest rates and ultimately threaten the U.S. recovery.

This is an advance warning because long-term interest rates are still very low. Even if they rise from here, their impact on the economy may not be felt right away.

But if you hold long-term bonds, you need to get out NOW — before you suffer further damage. Be sure to hold shorter-term bills and medium-term notes!

Using nearest futures contracts as the metric, the price of a 10-year Treasury note tumbled from a high of 130.09 on December 18, 2008, to a low of 114.98 on June 18, 2009.

It then spent most of the year’s second half trying to recover from that debacle.

But just in the last few days of December, while most traders were away or asleep, a renewed plunge in Treasury-note prices erased nearly all the gains since June … threatening new lows, paving the way for a new plunge in prices, and driving a new surge in 10-year yields.

The price decline in 30-year Treasury-bond prices has been even more dramatic: An historic 27-point plunge from 142.62 on December 19, 2008, to 115.67 on June 18, 2009 … followed by a feeble recovery … and now, as with Treasury notes, a new, ominous price decline and surge in yields.

The impact on consumers is unmistakable:

Even while Washington seeks to flood mortgage markets with easy money, 30-year fixed-rate mortgage rates are moving sharply higher. And even as the Fed does everything in its power to get Americans to spend, U.S. banks are tightening their credit standards and slapping on new fees.

The causes of the bond market troubles are equally obvious:

We have …

1. The biggest and most permanent federal budget deficits in our country’s history — $1.4 trillion of red ink in fiscal 2009 and AT LEAST another $7 trillion in deficits over the next decade.

2. The biggest government borrowing binge of all time. Just in the last week of the year, the Treasury Department borrowed $44 billion with the sale of 2-year notes, $42 billion with 5-year notes and $32 billion in 7-year notes, for a total of $118 billion — a new record. Expect more of the same throughout 2010.

3. The most inflationary monetary policy of all time, including a sudden, record-smashing DOUBLING of the nation’s monetary base in 2009.

And most ominous of all …

A Government Gone Wild!

This is not a matter of personal opinion or political philosophy. Regardless of your particular persuasion, you cannot deny the folly of Washington’s escapades …

• The U.S. Federal Reserve has tossed its traditional rulebook in the trashcan. It has opened its credit window to brokerage firms, guaranteed trillions of junk credit of the private sector and bought up over a trillion in junk mortgages.

• The U.S. Treasury has bailed out the nation’s largest and most outrageous risk-takers — not only institutions like Fannie Mae, Freddie Mac, Citigroup, Bank of America, AIG, and GM … but, indirectly, also high-rollers like Goldman Sachs and JPMorgan Chase.

• And now, adding madness to insanity, the U.S. government is opening the gauntlet to even more of the same:
  

  
  On Christmas Eve, the Treasury Department announced it will remove the limits on any and all aid to Fannie Mae and Freddie Mac for the next three years.

The intended consequence was to allay investor concerns that these two mortgage giants will exhaust the available government bailout funds.

Treasury officials know that an estimated 3.9 MILLION U.S. homes went into foreclosure last year … and, they know that they can expect more of the same in 2010. So they’re literally pulling all stops to funnel funds into this market.

But the unintended consequences are potentially greater concerns:

• An even deeper hole in the federal budget,
• An even larger avalanche of Treasury borrowings,
• Still lower bond prices, and, inevitably,
• Far higher long-term interest rates.

Most Financial Institutions Highly Exposed

If America’s financial institutions were prepared for higher interest rates, this might not be quite as serious. But as I demonstrated here two weeks ago, nothing could be further from the facts. (See "Three Government Reports Reveal New Looming Risk.")

Specifically …

• The Federal Deposit Insurance Corporation (FDIC) reports that many more banks are now taking on higher levels of interest-rate risk, leaving them overly exposed to rate rises at precisely the wrong time. They’re stuffing their portfolios with long-term mortgages, which invariably fall in value when interest rates rise. And they’re relying too heavily on short-term financing, which will inevitably be more expensive when rates rise.

• The U.S. Comptroller of the Currency (OCC) reports that America’s largest banks now hold $172.5 TRILLION in derivatives that are directly linked to interest rates, the most of all time. That’s over THIRTEEN times the amount they hold in credit derivatives — a primary cause of the 2008-2009 debt crisis.

• And the Federal Reserve reports that banks aren’t the only ones vulnerable to higher interest rates. Also exposed are credit unions, life and health insurance companies, plus property and casualty insurers.
  

Bottom line: Don’t march into 2010 as if the word “risk” had been stricken from investment lexicon like four-letter words in a grammar school dictionary.

It hasn’t been; it’s still there. And it mandates continuing caution — to buy excellent values … with strong fundamentals … prudent risk management … and plenty of cash in reserve.

Good luck and God bless!

Martin

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Money and Markets (MaM) is published by Weiss Research, Inc. and written by Martin D. Weiss along with Nilus Mattive, Claus Vogt, Ron Rowland, Michael Larson and Bryan Rich. To avoid conflicts of interest, Weiss Research and its staff do not hold positions in companies recommended in MaM, nor do we accept any compensation for such recommendations. The comments, graphs, forecasts, and indices published in MaM are based upon data whose accuracy is deemed reliable but not guaranteed. Performance returns cited are derived from our best estimates but must be considered hypothetical in as much as we do not track the actual prices investors pay or receive. Regular contributors and staff include Kristen Adams, Andrea Baumwald, John Burke, Marci Campbell, Amy Carlino, Selene Ceballo, Amber Dakar, Dinesh Kalera, Red Morgan, Maryellen Murphy, Jennifer Newman-Amos, Adam Shafer, Julie Trudeau, Jill Umiker, Leslie Underwood and Michelle Zausnig.

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