Crumbling U.S. Treasury Bond Market Suggests Spike in Interest Rates 2010

The holiday season is here — and in just a couple of weeks, 2009 will fade into the history books. I truly hope that you and your family enjoy these happy times.

But before I sign off for the year, I feel obligated to address one of the biggest threats to your wealth that’s looming in 2010. I’m talking about the very real prospect of “failed” Treasury auctions, plunging bond prices, and a big spike in long-term interest rates.

We touched on this issue briefly a week ago. But this time, we’re really going to get our hands dirty!

The Warning Signs Are There. Please Don’t Ignore Them!

Each and every week, the U.S. government sells Treasuries to fund its operations. Four-week bills. Three-month bills. Six-month bills. One-month bills. Two-, 3-, 5-, 7-, and 10-year notes. And of course, the granddaddy of them all, the 30-year Treasury Bond.

The Treasury auctions offer those securities to all kinds of bidders — individual investors, banks, insurers, pension funds, mutual funds, and foreign central banks are among them.

The more aggressive the bidding, the lower the yields Treasury has to pay on the securities it sells. And the lower the yields, the lower the U.S. government’s financing costs.

When buyers are aggressive, Treasury can get away with paying lower yields.

For a while, the Treasury Department was able to sell almost anything and everything at rock-bottom yields. It didn’t matter if it was the shortest of short-term bills or the longest of long-term bonds. Investors were willing to pay up. That helped keep our cost of borrowing low and underwrote the massive deficit with little-to-no financial pain.

But now that’s starting to change.

Slowly but surely, investors are beginning to appreciate the seriousness of the dangers we highlighted many months ago. All the mega-bailouts … all the Fed money-printing … all the fiscal recklessness being practiced by both Democrats and Republicans alike are starting to spook bond market players.

Sure, they’re still buying very short-term Treasuries like mad. It’s not like the government is going to default tomorrow, or that inflation is going to surge overnight. But auctions of 10-year and 30-year bonds are getting progressively worse, with demand dropping as supply ramps up …

Weak Auctions a Prelude to Failed Ones?

One key measure of auction strength is the “bid-to-cover ratio.” This measures the dollar volume of bids versus the volume of Treasuries being sold. The higher the number, the more demand you have relative to supply.

At the last 30-year bond auction, held on December 10, the bid-to-cover ratio came in at 2.45. That was substantially below the recent peak of 2.92. The 10-year note auction, held one day prior, registered a ratio of 2.62. That too was sharply below the recent high of 3.28.

Another way to gauge auction strength is to see who’s doing the buying …

The number of central banks buying Treasuries has declined drastically.

If you have a high percentage of notes and bonds going to so-called “indirect bidders,” you can breathe a sigh of relief. That’s because important buyers like foreign central banks fall into that category, and we desperately need them to step up to the plate to keep rates low.

Unfortunately, the numbers don’t look good there, either. Indirect bidders only took down 40.2 percent of the 30-year bonds sold in mid-December. That was down from the 2009 peak of 50.2 percent in July. Their share in the 10-year auction was even worse — just 34.9 percent. As recently as September, indirect bidders were snapping up 55.3 percent of the notes being sold.

Bottom line: Long-term Treasury auctions are getting weaker and weaker.

We haven’t seen a so-called “failed” auction yet. That’s when the bid-to-cover ratio drops below 1 — meaning the government can’t even get $1 in bids for every $1 in securities being sold. But that has already happened in the U.K., and I believe it’s only a matter of time before it happens here.

Defensive Measures to Take …

If you’re a defensive investor, your course of action is simple: Avoid long-term Treasury debt. Don’t put in bids for long-term notes and bonds via the Treasury Direct system or through your broker, and consider selling whatever long-term holdings you already own.

That strategy is one I’ve been advocating for a long time. And boy do I hope you’ve been listening! Just consider this: If you purchased the iShares Barclays 20+ Year Treasury Bond Fund (TLT), an exchange traded fund (ETF) that owns long-term Treasuries, at the end of 2008, you would have already lost more than 20.5 percent! That INCLUDES interest payments, by the way.

As a matter of fact, 2009 has been the absolute WORST year for total return on long-term Treasuries since at least 1973. That includes dismal years such as 1994 and 1999, which occurred during Fed rate-hiking cycles.

Until next time,

Mike

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Comments

Ron S.

19 Dec 09, 03:40 Thank you for explaining Treasuries!

There are many people, like myself, who have limited understanding of economics, and finance, in general. Details of how the Government finances it's expanding debt have been particularly hard for me to find. Your brief explanation regarding Treasuries and the auctioning process is one of the best I've read, anywhere. Thank you so much. Ron S. Spokane, WA

