The Bond Market's Dilemma

I realize this hit the blogosphere yesterday via Bloomberg but I wanted to share it in case some of you missed it:

My Take:

Bloomberg reported that our public debt should equal 100% of GDP by 2012 at the rate in which we are spending.

If you were to add our private debt onto the debt number it would now exceed 370% which dwarfs any other credit bubble ever seen in this country including The Great Depression as seen below:

My Take:

As you can see above The Great Depression was a walk in the park when you compare to the mess we have gotten ourselves into this time.

The trillion dollar question I have is what does the bond market do now in response to such massive deficits?

There are essentially two scenarios regarding treasuries that the bond market is predicting as the world wide debt contagion continues to get legs.

Scenario #1 is the 10 year yield collapses under 2% as we sink into a deflationary collapse ala Japan in the 1990's.

Scenario #2 is the 10 year yield soars to near double digits as the bond market pulls a "Greece" on us and take yields higher until we massively reign in spending.

We have seen a milder version of scenario #2 as recently as the early 1990's during the Clinton presidency when he tried to implement an extremely costly version of national healthcare at a time where our deficits were already high as a result of cleaning up the remnants of a housing bubble....Gee does that sound familiar?

The bond market took yields up to over 6% at the time in response to the Clinton spending binge. Everyone then freaked out because it put the housing recovery at risk as a result of rising mortgage rates.

Clinton then decided to run away from his spending agenda faster than he did from Hillary after she out there was a blue dress floating around Washington DC with a white stain on it.

So will it be Scenario #1 or Scenario #2?

I think it's too early to tell. I think the bond market has an extremely tough decision to make here. One of the top bond funds just announced that they are selling all of their treasuries now that our debt levels have now just about equaled our GDP.

On the flip side you have Europe and the primary dealers running into bonds because nothing looks safe.

Edit: As I type I just noticed the market is falling once again and the 10 year is rising so the flight to safety into bonds still appears to be on. Gold is also up sharply as well so there plenty of scared money also flowing into the metals. Market is selling off sharply into the close.

Back to my point: The question is will there be a "Come to Jesus" moment where everyone realizes our paper is no better than anyone elses because our debt levels are just as bad?

Another question to ask is are the bond vigilantes concerned that if they take rates higher they blow themselves up in the process? It's a fair question for them to ask themselves because the economic system will be at serious risk of collapse if lending rates soar.

The Bottom Line

This is the most dangerous market I have ever encountered. Play small and stay mostly in cash.

If you are curious as to what my holdings are right now I am long GLD and SLV. Short the S&P with a small position of SDS. Short treasuries via TBT. All of these positions are small except for my gold holdings which are still small considering it consists of less than 10% of my total portfolio.

I stand mostly in cash and I have about a 25% position in bonds. PIMCO's (PTTRX) is by far my largest bond holding. Bill Gross is the best bond guy on Wall St as far as I am concerned.

As for which way the 10 year moves going forward I think the jury is still out. I could see either of the two scenarios playing out.

If Europe's debt contagion continues to spread like wildfire its going to eventually force a selloff in treasuries. However, I think we will be the last ones to fall so bonds coud rise in the near term.

I am short some US treasuries simply as a hedge to my longer bond holdings.

The risk of a complete meltdown in the bond market where yields soar to over 10% is also a real threat in my view. As we saw in Greece it can happen in a matter of days so be careful if you hold a lot of treasuries.

On the flip side, a Japan style collapse in the bond market where yields collapse under 2% is also a possibility and cannot be ruled out either as the velocity of money comes to a complete halt.

The best analogy that I can relate this market to is to compere it to a pilot that is trying to land a plane in severe cross winds. The wind could turn on a dime when he least expects it and the result would be a catastrophic crash. This is why you need to stay diversified and protect yourself for either scenario.

The reality is we may see both scenarios over the long term as this thing plays out. We saw both deflationary and inflationary panics in the late 1970's/early '80's crisis. Gold would move $50 in both directions on any given day as Wall St tried to interpret what was happening in the markets.

Several investment banks went belly up in the early 1980's as they bet the house on borrowing at low rates on the short end and then buying the long bond. Volker ended up taking them down when he raised the interest rates on the short end in order to reign in inflation.

These banks that went down were not hedged enough and got addicted to cheap money. I am sure the same thing is happening now as banks borrow from the Fed at zero and then buy high yielding investments.

It will be interesting to see what the bond market does moving forward. What will be interesting this go around is it will be the bond market not the Fed that takes rates higher IMO. This adds a wrinkle into how this scenario plays out.

If the vigilantes come out of hiding and take rates higher there will be many banks that are caught on the wrong side of the trade and will be immediately insolvent.

The scary thing is it will be the primary dealers that will be in the most trouble because they are the ones that are up to their eyeballs in treasuries. The (too big to fails) will immediately become(too big to save) if treasuries yields soar.

A few things before I go:

If you are looking for ideas as to where you should sit in cash, I personally prefer money markets and FDIC reserve deposit sweeps myself as long as they are under the guaranteed limits. Fidelity's sweep puts you in 3 different banks in order to spread out your risk which is a nice option.

The DOW ended up with another triple digit loss today. We now sit at 1050 on the S&P. 1040 is a key resistance area. If we break that area of resistance there is nothing but air until we get down to the 900 area.

If we test 1040 and don't hold expect to see some significant selling pressures which will put the S&P into triple digits.

Be careful out there. This bear market is starting to growl once again as it begins to dig its claws into the heart of the bull market.

Disclosure: Long GLD and SLV. Short SDS. Long TBT and PTTRX.