Treasuries Are Toast

08/13/2009 10:34 am EST

Focus: MARKETS

Mary Anne & Pamela Aden

Co-Editors, The Aden Forecast

Mary Anne and Pamela Aden, editors of The Aden Forecast, say the decades-long bull market in long-term Treasury bonds will come to an end soon.

Bond prices have dropped sharp­ly this year, the most in 30 years. This alone tells us that bond inves­tors are getting nervous; they’re concerned about future inflation and they’re cutting back on their bond purchases or selling them.

Foreigners own about half of all US government bonds, the highest level ever. And the bulk of those bond holders are foreign governments. Many of these gov­ernments are holding hundreds of billions of dollars in US bonds, [and] foreigners have been selling bonds since last year when the global financial crisis worsened.

What’s worrisome is that sell­ing is intensifying as governments continue to voice their concerns about massive US spending, the likelihood of future inflation, the negative outlook for the US dollar, and the general direction the coun­try is taking.

China is the US’s largest lender to the tune of around $1.5 trillion. It wants assurances that its loans are going to be OK, and top government officials, in­cluding Treasury Secretary Timothy Geith­ner, have promised to shrink the deficit by 2013. [But] the Chinese will want to see actions, not words.

Long-term interest rates [are] headed higher in the months and prob­ably years ahead as inflation becomes more obvious, especially com­bined with the new low in the US dollar.

And considering the government’s going to need four or five times more money than it needed last year, this interest rate premium will likely shoot up much higher than most people realize.

Short-term interest rates are another story. The Federal Reserve is keeping them low and it probably will for as long as the economy remains on thin ice. But eventually, short-term rates will fol­low long-term interest rates up, and we’re now probably seeing the lows for interest rates for a long time to come.

It’s now important to watch the major up trend that’s been in force since the 1990s. If the bond price breaks clearly below that trend, bonds would be extremely bearish and they’d probably then be headed for a mega-drop similar to the one that happened in the 1970s. At that time, bond prices plunged about 70% as long-term interest soared, [with long-term rates] eventually peaking over 15% in 1981.

We don’t yet know if bonds will react as dramatically this time around, but we do know that all of the ingredients are in place, so they could. The first two solid signs would be a break below that long-term up trend and/or a sustained rise above the megatrend identifier at 4.67% on the 30-year yield. If that happens, you’d want to sell any bonds you may be holding. For now, it still looks like long-term interest rates are going to decline first before they head higher because they remain temporarily overbought. This will provide a good opportunity to sell some bonds, for those of you who have them.

It’ll also provide a great opportu­nity to buy into a rising rate fund, or to short bonds. That way, we’ll get in at a better price and be well positioned to take advantage of the big rise in rates, probably starting in the months ahead.

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