This from The Sovereign Society:

In the last few weeks, Treasury yields have been headed upward – from 2.63% a month ago to 3.33% today on 30-year bonds – and everyone’s been asking whether the bubble has finally blown out.

The “Treasury Bubble” became the new boogeyman for many experts and media pundits last year. Its “impending” collapse could potentially crush the U.S. government and throw the dollar into rampant hyperinflation.

But is it a bubble at all? And if so – or not – what’s your most prudent course of action?

That’s what we’ll be talking about today, on the heels of Ben Bernanke’s latest announcement that he’d consider purchasing long-dated bonds in the open market to manipulate yields. Will Bernanke’s plan be the final nail in the coffin for the U.S. economy and the dollar, or will it further propel a 27-year bull market in Treasuries?

Just the Facts…

That we’ve been in an almost thirty-year bull market for Treasuries is perfectly clear.

Since October of 1981, when yields hit 15.21% on long-term bonds, Treasury yields have been on a downward trend. And aside from a few reversals in that span of time, yields have consistently been lower each year.

But Bill Gross – Manager of PIMCO’s Total Return Fund – admits that the Treasury market is showing “some bubble characteristics,” and reiterates a previous statement, “…I have said for the past three months, the governments are very overvalued.” Do Gross’ cautious statements back up the allegations of Peter Schiff and other “Treasury Bubble” proponents?

The very essence of a bubble is that it’s unsustainable in the long run. So let’s ask the question; what happens if this bull market continues and 30-year government paper reaches a yield of zero?

Sustained rates at that level would indicate the market’s belief that we’re in a deep depression. Essentially, the market would be saying that it would rather park money with the government for 30 years – with a guaranteed return of zero – than risk it in private-sector investments. Retirement fund managers would be forced either to adjust their expected returns or abandon Treasury debt altogether.

But investors in zero-yielding Treasury paper would actually be taking on more risk than they might expect. And that’s the risk of a rising interest rates…

Interest Rate Risk

Even if Treasury yields reach zero, it’s not likely they’ll stay there forever. And when yields once again start to rise, it puts the capital investment of bondholders at risk.

Let’s say for example that Treasuries are yielding zero and you purchase a US$1,000 dollar note without any discount (so you’re paying US$1,000 for the bond). Then, rates eventually rise to 1%. That means that buying the same bond will only cost you US$990, even though you’ll still be reimbursed the full US$1,000.

That means you’ve essentially lost 1% of your original capital investment, as the market price of your bond would change to reflect the new issue yielding 1% more than your original purchase. As you can imagine, the lower yields get, the greater the risk to an investor’s capital is likely to be.

The “Treasury Bubble” and YOUR Money…

It’s hard to tell whether Treasuries are currently in “bubble” mode.

Unfortunately, most bubbles just aren’t diagnosed until after-the-fact. While they’re clear in hindsight and defining “unsustainable” levels is easier after the bust, the real defining attribute of a bubble is the rampant sell-off and ensuing havoc that come once the bubble has popped.

So should you join in with the “Bubble-phobia” and steer clear of Treasuries?

It’s a good idea to steer clear of Treasuries right now, but not because the Treasury-bubble-boogeyman is hiding under your bed. Simply put; the interest rate risk seems far too great for the meager reward of near zero-yielding Treasury securities. In light of the news, we can safely expect Bernanke to do everything in his power to suppress that long end of the curve. And we can probably expect the market – in turn – to continue to disagree, leaving Treasuries in a relatively volatile position.

Instead, Investment Director Eric Roseman believes there’s a case for select issues of Investment-Grade Corporate debt. It’s also a great time to look at gold, “With interest rates now at 0%,” Eric recently said, “the cost disadvantage to holding gold has vanished because high quality Treasury bond yields have plummeted while T-bills pay nothing. Gold will probably safeguard your capital better than paper money in this environment.”

Source: The End of the Treasury Bubble?

This from Sovereign Society:

With yields as high on municipal debt as they’ve been in years and the President-elect’s office all abuzz with news of stimulus for state and municipal governments, the cunning investor is paying attention. The bailout of the financial system is already leading to some serious opportunities in commercial debt, so should you get ahead of the curve and dive into municipal debt?

In a word; no. At least not yet.

After all, big government curing our economic woes with “stimulus” projects is almost like a drug dealer curing withdrawal symptoms with more heroin…you just can’t help but wonder whether his medicine is exactly what got you there in the first place. Regardless, we’ll indulge popular thinking and acknowledge the fact that the government is now prepared to throw piles of free money at this sector of the economy.

But hold on just a second…what’s that percolating in D.C.? US$1trillion won’t do the trick, they say. Everyone from Bernanke to Riksbank-prize-winning economist Paul Krugman say that we’ll need more… possibly US$2trillion, or even more than that. And Obama has certainly indicated that he’d be open to that kind of discussion.

Now, let’s glaze over the fact that I could personally put another man on the moon – and probably Jupiter – with that kind of loot. And while we’re at it, we’ll glaze over the potential US$3trillion in government spending in 2009 (more than any government has spent in a single year since humans started governing).

No, let’s be professional about this, and in the words of Ricky Roma from Glengarry Glen Ross, “You never open your mouth until you know what the shot is.” So let’s figure out the shot…

Bloated State & Local Governments…

In the period between 1960 and 2000, the Federal Government went from two million total employees to three million. This difference didn’t even track the total growth in population over that period. But in that same period, state and municipal governments went from six million total employees all the way up to 20 million.

And since then, the situation hasn’t really improved. When the “War on Terror” terrified us into giving up a greater portion of our personal liberties for the promise of “security,” these payrolls ballooned again.

Think about it in practical terms; when was the last time you went to the DMV or the county courthouse? There were at least a handful of TSA-style security guards to frisk and scan you…since everyone’s a terrorist until proven innocent these days…who do you suppose pays their bills?

Why you do! And you also pay for another 20 million more state & local employees who rely on over US$74 billion in your annual taxes to keep a roof over their heads. But you have to remember; these outfits aren’t run with the trademark efficiency of business titans like IBM or Microsoft.

Instead – as you can see from the chart at the left – they constantly waffle back and forth from periods of excess savings to periods of excess debt (note that the Census data for this chart ended in 2007…when our crisis was just beginning and state & local governments held a collective savings rate of -10%!)

Sovereign Society Investment Director Eric Roseman chimes in, “The growing funding concerns facing municipalities has already spread to several states, including California, which requires cash to finance a massive budget gap in 2009. California, with a long string of budget deficits has declared a State of Emergency in December as the state runs out of cash. California is the largest issuer of muni debt.”

“What’s truly alarming about December’s scrapped Port Authority offering was the short duration of the fixed-income term of only three years. Investors would typically embrace a short-term note that pays a tax-free yield. But these are not normal times.”

“The rating agencies have also confused investors since the market has lost confidence in their ability to accurately rate and rank credit offerings.”

“As the U.S. economic recession deepens into 2009 it would be advisable to avoid tax-exempt municipal bonds, despite their attractive yields. The risk is too high. You’ve got to believe that many more cities, towns and states will suffer from a credit squeeze coupled by a lack of buyers as revenues continue to decline in a deteriorating economy. Avoid muni bonds.”

Source: When a Trillion Dollars Just Won’t Do…

This from The Sovereign Society:

It’s often the case that the most important news isn’t what’s happening in the world today, but what’s not happening in the world today. Case in point; President-elect Obama’s constantly growing stimulus is not driving the market upward.

Going back to the Fall of 2007, the Fed’s interest rate cuts served as an immediate boost that pushed the markets higher. As planned, these infusions of credit helped to boost market confidence and morale…even if only for a few days or weeks.

Their effect lessened and lessened as time went on…and the boost from December’s rate cut only lasted a few sessions before being gobbled up by market uncertainty. Now, President-elect Obama is pulling out literally all of the stops in declarations about his planned stimulus…

A few states looking for a few hundred billion quickly grew into a US$1 trillion stimulus package. And the US$1 trillion stimulus package quickly grew into multiple years of US$1 trillion budget deficits. 1.5 million new jobs balloons to 4 million new jobs…but the stock market doesn’t even flinch.

What gives? With what seems like a promise to write blank checks, infusing seemingly unlimited amounts of credit into the flagging economy, why isn’t Obama’s stimulus effort gaining any short-term traction in the marketplace?

It’s a (Liquidity) Trap!!

In monetary economics, a ‘liquidity trap’ happens when a Central Bank’s nominal interest rate reaches zero and investors stop expecting significant returns on their financial and real investments…and start sitting in cash.

Think about it; cash only ever yields zero. But when the Fed’s interest rate hits zero, the same is true of short-term credit. The two are comparable in terms of reward…both yield zero. So there’s no incentive to take a risk and lend when you can expect the same returns from hoarding cash. This is true for both consumers and businesses, and it’s especially true when you account for the increasing default risk and general uncertainty that have become commonplace in today’s markets.

So in its efforts to stimulate the economy, the Fed is actually doing the exact opposite…slowing the economy by adding even more incentive to hoard cash in these troubling times.

As a result, the marketplace becomes resistant – if not outright immune – to further infusions of credit. Be it through trillions in deficit-spending “stimulus,” or the witchcraft of quantitative easing, the job of stimulating the economy after implementing a zero interest-rate policy becomes much, much more difficult.

And in light of recent news covering the precipitous drop in consumer demand, you’d be hard-pressed to find Obama’s planned stimulus showing any traction in the marketplace. Combined with the rising savings rate, the current freefall in consumer demand means disaster for corporate earnings and – in turn – share prices. This gradual realization will likely continue to offset any boost offered by Obama’s continued pep talks.

In reality, Obama’s pledge to make a new “New Deal” with the American people should be significantly boosting the economy. After all, the prevailing wisdom is that these kinds of policies helped us through the great depression. Those who were crossing their fingers for an “Obama Stimulus Rally” were almost spot-on…except they forgot about one thing.
The onerous burden of Central Bank policy.

No…it appears as though we won’t see a stimulus rally in January after all. And with any rally’s momentum deadened by the liquidity trap, one could reasonably expect that the market has reached its short-term peak.

Source: Federal Reserve Torpedoes Obama’s Stimulus Rally