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Treasury Bull Alive and Kicking


Market still intact after 27 years.

The US Treasury bull market is still intact after 27 years.

30-Year Long Bond, 1990-Present

Click to enlarge

Note: That's as far back as stockcharts goes, but that is indeed the valid trendline currently in play.

Real Interest Rates Are High

Many have been stating that treasuries are in a bubble, the bond market is reacting irrationally, the treasury market is manipulated, and all sorts of other similar statements. Who wants to buy a 30-year treasury at 4.3% when "inflation" is so high?

Most who believe in the treasury bubble or massive inflation point to the CPI as a reason.

I tackled the issue of the CPI in Real Interest Rates Are High. My conclusion is this: If housing was adequately represented in the CPI, the value would be sitting at 1.3%, not 5.6%. The claim is based on the Case-Shiller housing index in the CPI, instead of on Owner's Equivalent Rent.

Housing prices -- not some fictional rental value obtained as if one rented a house from oneself -- belong in the CPI. Houses are consumer goods, regardless if one buys a house every year or not. People don't buy autos or computers or fishing poles every year, either.

This is not a call for the Fed to lower interest rates, it is merely an attempt to show that the treasury market is not by any means acting irrationally. I have stated before and I will restate it now, the Fed has no idea where interest rates should be and that micro-management of interest rates by the Fed is exactly what has been causing bigger asset bubble after bigger asset bubble.

Fed Has Lost Control

Please see the Fed Uncertainty Principle for more on how the very existence of the Fed distorts the economic picture so badly that it creates self-reinforcing feedback loops that eventually blow sky high.

The high real interest rates that I claim we have are a function of high demand for money but no supply. In other words, the current repo system is completely broken and the Fed has totally lost control of the system.

Every step the Fed is taking is an attempt by the Fed to regain control of the system. So far every step has failed.

Failed Steps

  • The Term Auction Facility (TAF)

  • The Term Security Lending Facility (TSLF)

  • The Primary Dealer Credit Facility (PDCF)

  • Shotgun marriage between Bank of America (BAC) and Countrywide

  • Naked shorting rules selectively enforced

  • Treasury Secretary Paulson seeking -- and getting -- blank check approval from Congress to buy unlimited stakes in Fannie Mae (FNM) and Freddie Mac (FRE)

  • The Fed granting waivers for private equity firms to invest in banks

  • Suspension of FASB accounting rules for a year

For more on the FASB postponement, please see Not Practical To Tell The Truth.

US Banking System Is Insolvent

There is a very good reason for every step to fail: The banking system itself is insolvent. I listed 25 reasons in You Know The Banking System Is Unsound When... Here are reasons 1, 24, and 25.

1. Paulson appears on Face the Nation and says "Our banking system is a safe and a sound one." If the banking system were sound, everyone would know it (or at least believe it). There'd be no need to say it.

24. There's roughly $6.84 trillion in bank deposits, of which $2.60 trillion is uninsured. There's only $53 billion in FDIC insurance to cover $6.84 trillion in bank deposits. Indymac alone will eat up roughly $8 billion of that.

25. Of the $6.84 trillion in bank deposits, the total cash on hand at banks is a mere $273.7 Billion. Where's the rest of the loot? The answer is: In off-balance-sheet SIVs, imploding commercial real estate deals, Alt-A liar loans, Fannie Mae and Freddie Mac bonds, toggle bonds (where, amazingly, debt's paid back with more debt) and in all sorts of other silly (and arguably fraudulent) financial wizardry schemes that have bank and brokerage firms leveraged at 30 to 1 or more. Those loans can't be paid back.

What can't be paid back will be defaulted on. If you did not know it before, you do now. The entire US banking system is insolvent.

Demand For Fiat Currency

At 30 times leverage all sorts of malinvestments and financial wizardry schemes were funded. Here are some examples:

  • The shopping center economic model
  • Stated income "liar loans" to fund housing
  • The originate to sell model
  • SIVs
  • Toggle Bonds
  • Hedge fund speculation

Incredibly, this very situation creates a demand for fiat currency for which to pay back debts.

What's Happening With Gold And Currencies?

Inquiring minds are likely puzzled by the incredible demand for fiat currency over gold. Inquiring minds may also be puzzled by the strength of the US dollar over seemingly better Euros, Canadian dollars, etc.

Let's tackle currencies first. I addressed the US dollar in Currency Intervention and Other Conspiracies. Dollar bears and commodity bulls were warned many times. It's not manipulation schemes driving the dollar, but rather an unwinding of leveraged anti-dollar bets on a rising euro, rising commodities, etc. There was widespread belief that Europe would decouple or would at least avoid a recession that the US was in.

When the decoupling myth was finally shattered for good, the Great Unwind in Gold and Silver began.

Deflation Sets In

Many are in denial still, but deflation is right here right now. The case was made in The Future Is Frugality. Here are the key bullet points:

Deflation Isn't Coming, Deflation Is Here.

  • Credit is contracting by any reasonable measure. It would be contracting at a stunning rate if marked to market. And from a practical standpoint marked to market is how it must be considered, even if there is no direct measure (which I might add is on purpose). Instead it is still hidden in marked to fantasy level 3 assets and in SIVs and other off balance sheet vehicles. See Not Practical to Tell the Truth for this line of reasoning. M3 is simply not a reasonable measure of credit, nor is MZM. Inquiring minds will want read Bank Credit Is Contracting for more details.

  • Trillions of dollars of housing wealth has been wiped out, yet laughably some still talk of hyperinflation. There has never been a hyperinflation in history where land prices have fallen like they are now. In fact, there has never been hyperinflation where land prices have declined at all, barring some obscure war zone perhaps.

  • Bank writeoffs have hit $500 billion and $2 Trillion is coming. "Yes, That's $2 Trillion of Debt-Related Losses", says Nouriel Roubini.

The only question now is how long deflation lasts, not whether it gets here. For more on deflation, please see Deflation in a Fiat Regime.

Should Gold Sink In Deflation?

Inquiring minds are likely asking: If gold is money, and money gets more valuable in deflation, then why should gold be sinking?

Even though I have stated gold will do well in deflation, I have also stated that in the initial phases of deflation gold would likely be hammered as leverage everywhere was wiped out of the system. Some of that leverage is being destroyed right now. Indeed Commodity Hedge Fund Ospraie Shuts Down After Losses. It wasn't the first hedge fund to blow sky high - and it won't be the last either.

Leverage being reduced creates a demand for dollars. And dollars, contrary to popular belief, are actually in relatively short supply. The apparent conundrum is in mistaking credit for dollars. And when asset prices are sinking, and leverage is 30-1 (or more) -- as it is with banks and brokerages and hedge funds -- that credit simply cannot be paid back. Attempts to do cause assets to be sold are ever-diminishing prices.

Leveraged trades, including gold, are now being unwound for the safety of treasuries. This explains the feeble rally attempt in gold during what should be a seasonally strong period.

Gold could turn around now or it might not. I have seen many reports calling for new highs by the end of the year, a strong seasonal bounce, etc. My personal guess was a weak but playable rally. It's becoming increasingly likely that there may not be a rally at all, or if one does come it will be from a much lower level.

The fact of the matter is that everyone is guessing and bottom callers have been fueling the decline by plunging in then stopping out. Furthermore, the surge in demand for gold and silver coins is potentially a very contrarian indicator. Since when has the small retail investor gotten anything right?

Key Questions For Gold, Commodity, Energy Bulls

What if you are wrong and prices head lower? Where is your stop?

Certainly the more overweight one is, the more important the answer is. Someone with a 5-10% position in gold and otherwise high cash positions is going to feel a lot differently about this selloff than someone who went all in when gold touched 850 thinking a big bounce was coming.

Deflation Models

I had several models for how deflation might play out. Here they are.

1. Everything but treasuries sink
2. Everything but treasuries and gold sink
3. Gold sells off initially, then rallies with treasuries

Yes, this treasury bull is extremely long in the tooth. And yes there will be a time to short treasuries. But there has not been a bull market in history, in anything, that ended with that asset class being nearly universally despised.

And make no mistake about it, treasuries are despised. Foreign central banks do not count because they are not buying treasuries to make a profit, and they are relatively unconcerned about losses.

All things considered there is genuine pent up demand for treasuries right here in the US should foreign buying subside. The reason is simple. It is far better to make 3% in treasuries than to lose 30% in equities, commodities, or corporate bonds.

Potential For Deflationary Crash

At this juncture the markets are definitely in a potential deflationary crash mode. And as stated above, I believe the Fed is essentially powerless to do anything about it. The Fed cannot possibly bail out every bank, brokerage, airline, and automotive company that is in dire straits. They cannot force sovereign wealth funds to do so either.

There's little doubt that the Fed will try all sorts of schemes, but all those who were 100% sure Bernanke could do something better be asking what if he doesn't? Those who thought gold, silver, or energy was a one way bet better be asking the exact same thing.

In the meantime, the much despised treasury bull is alive and doing fine.
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