The Treasury bubble and what to do about it

US Treasury bond yields have been falling for nearly 30 years. But now, says Tom Dyson, the Treasury bubble may have popped. So is it time to bet on a rise in Treasury bond interest rates?

Treasury bond yields have been falling for 27 years. Eight weeks ago, they moved into the 'blow off' stage.

I use the 30-year Treasury bond as the benchmark for this market. On October 27, the 30-year bond closed with a yield of 4.37%. After eight straight weeks of declines, it fell as low as 2.52%.

It's been one of the most relentless moves I've ever seen in the markets. Especially the Treasury bond market, which is normally tranquil. The 30-year Treasury bond now pays the lowest yield it's ever paid, and the recent decline is the biggest two-month fall in its history.

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I believe the Treasury bubble has now popped, and it's time to start betting on a rise in Treasury bond interest rates.

First, Treasury bonds have garbage fundamentals. The Treasury is about to flood the market with supply. For example, the Treasury plans to auction more November 2018 10-year Treasury notes. It's already sold $36 billion of this bond in the last two months. Today, it will sell another $16 billion or so. That's $52 billion maturing in November 2018. In addition to increasing the size of its auctions, the Treasury has also increased the frequency of its 10-year bond auctions from eight times a year to 12 times a year.

At the exact same time, demand for Treasury bonds is about to fall off a cliff. The world's two largest customers the Japanese and the Chinese buy Treasury bonds with the money they earn from exporting goods to the United States. But now that the American consumer is broke, Asian exports will collapse. Less money will flow into the Treasury bond market.

Meanwhile, the Federal Reserve is inflating the money supply so fast, no one's seen anything like it before. Last week, for example, the Federal Reserve published its plans to buy $500 billion of mortgages issued by Fannie Mae, Freddie Mac, and Sallie Mae using freshly printed dollars. (Read the Fed's FAQ on this scheme here.)

It's the perfect recipe for a massive rise in Treasury bond yields.

Here's the thing: Before you try to short a bubble in the financial markets, you must wait for the bubble to burst or you are liable to be wiped out in the final irrational stage. Imagine trying to short technology stocks in 1999. The Nasdaq Index doubled in the final six months of the bubble. You would have lost a fortune.

In the last two business days, yields on Treasury bonds have reversed. They surged from 2.56% to 2.81%. This is good evidence of a trend change from falling yields to rising yields. The amazing thing is, yields rose despite recent news that should have made them decline.

On Wednesday, the US Labor department reported the initial jobless claims number. Economists said this statistic wasn't meaningful because it covered the Christmas week. Also, winter storms crippled the North East last week, so many people couldn't leave their homes to sign up for unemployment benefits. The day this 'meaningless' news came out, bond yields jumped by 0.11% (it doesn't sound like much, but for the Treasury market, that's huge).

Then on Friday, the Institute of Supply Management reported its index of US manufacturing activity had fallen to its lowest level since 1980 and its index of new manufacturing orders had fallen to its lowest reading since 1948. News like this should make bond yields fall. They rocketed higher by another 0.13% that day.

Treasury yields are ignoring news that should make them fall and rising on news that shouldn't have any impact. It tells me the path of least resistance is to higher yields... and the bubble in low Treasury bond yields finally burst on last Wednesday.

My favorite way to play a rise in Treasury bond yields is the ProShares UltraShort Lehman 20-Year ETF (NYSE:TBT), which delivers twice the inverse of the long-term US Treasury Index.

This article was written by Tom Dyson for the free daily investment newsletter DailyWealth, and was first published on 5 January 2009.