Trading the Coming Bond Market Crash

The most spectacular bear market of the 21st century has started. We are now three months into a major long-term secular trend that I believe will continue for decades. Many of the brightest minds in international finance have already put size positions on. The early adopters will make fortunes.

The trigger for the next leg down in bond prices is the surprise announcement overnight of a compromise on an extension of the Bush tax cuts. Dividends and capital gains will continue to be taxed at a 15% rate. Estate taxes are capped at 35% and are tax free up to $5 million. Unemployment benefits have been extended by 13 months. And to really juice consumer spending, payroll taxes have been cut by 2%. You can really see that it was an “all of the above,” throw-in-the-kitchen-sink sort of compromise.

Politicians and taxpayers alike are popping open the champagne bottles. I’ll tell you what the Treasury bond market sees: an increase in the 2011 budget deficit of $450 billion and a massive surge in government borrowing and Treasury bond issuance. This is why bond prices have fallen off a cliff today and shorts bond plays are through the roof.

Here’s how deep and ugly it could get.

See also: 7 Keys to a Winning Trader

Taxpayers Love the Compromise, But the Bond Market is Taking a Big Hit

To say that things have gone well for the Treasury bond market this year would be a huge understatement. First, there was a global flight to safety triggered by the European debt crisis in the spring. Then we saw the mad rush by hedge funds to cover shorts in securities they believed were the world’s most overpriced assets. Out of nowhere, Ben Bernanke appeared on the scene with his quantitative easing. The perfect storm sent bond prices everywhere to 50-year highs and yields to all-time lows.

According to Professor Jeremy Siegel at the Wharton School at the University of Pennsylvania, the last time bond yields were this low, in 1956, bonds suffered negative returns for 30 years! At the August top in bond prices, the Treasury market was effectively discounting 0% inflation for ten years, an insanity I was happy to bet against.

Meet Your New Bond Fund Manager

The recent action in the markets suggests that the turn may finally be behind us. Why have bond prices been falling for the past three months, despite an assumed promise by the Fed to provide unlimited amounts of liquidity? Why has a ton of Chinese and other foreign buyers failed to propel prices to new highs? Is it possible that the fat lady is at last singing in the Treasury bond market? Instead of driving bond prices higher, the true net effect of QE2 could be merely to slow their descent. In November, 99 consecutive weeks of bonds fund inflows came to an abrupt halt and have seen only outflows since.

According to the Investment Company Institute, outflows from equity mutual funds over the last two years totaled $232 billion, while inflows into bond funds soared to a staggering $559 billion. Today, “bond funds” ranked with “Miss Universe” and “Lindsey Lohan” among Yahoo’s top ten search terms. No doubt the prospect of 80 million baby boomers bailing on equities so they can become coupon clippers for life is provided some extra juice for this market.

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Not as Popular as a Bond Fund?

The relentless whirring of the printing presses is so loud that they keep me awake at night, even though, according to Mapquest, I live 2,804.08 miles away. What will be unique with this meltdown is that it will be the first collapse of a bond market in history in a deflationary environment. It is not inflationary fears that will execute the coup de grace for the long bond, it will be the sheer volume of issuance. The Feds have to sell nearly $2 trillion of debt to cover a massive budget deficit and to refund maturing paper this year, easily the largest amount in history.

Pile on top of that hundreds of billions more in offerings from states and municipalities that are bleeding white. By the end of 2010, total government debt from all sources will rocket to a staggering 350% of GDP. At some point, the world runs out of buyers, and the long bond yields will begin their inexorable climb from the current 4.3% to 5.5%, 6% or higher. Even the ratings agency Moody’s is talking about a ratings downgrade for the U.S. debt. It’s just a question of how many sticks it takes to break a camel’s back. Once Bernanke finishes his thing with quantitative easing, then it is bombs away.

Historically, ten-year bond yields matched the nominal GDP growth rate. So an average 3.5% GDP growth for the past decade added to a 2.5% inflation rate gave you a bond yield trading around 6%. Today the math is from a different universe. A 2.5% GDP rate added to 0% inflation gave you the 2.5% yield for the ten year you saw glaring at you from your screen last summer.

Rampant Inflation Has Already Broken Out

There is one honking great problem with this scenario. Rampant inflation has already broken out in vast swaths of the global economy. Anyone who purchases precious metals, commodities, energy, food, health care, user fees of any kind, or a college education can tell you, not only that inflation is alive and well, it is flourishing. Residents of China (NYSE: FXI), India (NYE: PIN) and

Turkey (NYSE: TUR) and other emerging markets, and the commodity producing countries of Australia and Canada, can also tell you a lot about inflation.

The last place you can expect this stealth inflation to appear is in government statistics, a deep lagging indicator. And don’t ever expect inflation to show its ugly face where you want it the most, in your wages, pension benefits, 401k returns or the price of your home.

Given the strongly positive yield curve, where 30-year yields are trading at a 4.3% premium to overnight rates, this is the best time in five decades to sell Treasury bonds. Like a good Agatha Christie mystery, there are culprits for bonds’ impending downfall hiding behind every set of drapes. You knew the end was near with prime corporates, like Hewlett-Packard Company (NYSE: HPQ), suddenly floating 100 year debt issues.

The first mortgage I took out on a Manhattan coop in 1982 carried an 18% interest rate. That was when Federal Reserve governor Paul Volker was waging a holy war on inflation, which he eventually won. I took out one of the first ever floating rate mortgages, and by the time I sold it three years later, the rate had melted down to only 11%. I tell this story to kids buying their first starter homes now and they look at me like I’m some kind of dinosaur.

Is This a Top?

Total foreign ownership of U.S. Treasury bonds amounts to $4 trillion, up from $2.4 trillion in three years. Instead, the Chinese have been buying Japanese government bonds, which today carry a paltry 1.1% yield but have the merit that they are denominated in a rapidly appreciating currency. The Mandarins in Beijing have also been picking up a variety of bonds in Europe, which have seen yields pushed to near records thanks to the debt crisis there.

Officials at the People’s Bank of China say that it is all part of a broader diversification effort away from the greenback. PIMCO’s Bill Gross has apparently been taking Mandarin lessons on the sly because he has also been paring back his own massive holdings in longer dated Treasuries.

China Can’t Unload Those Treasury Bonds Fast Enough

I believe that we have seen the final blow-off top in the great 50 bull market in bonds. A decade from now, it will not be stock investors complaining about a lost decade, but owners of bonds. Like gold in 1979, technology stocks in 2000, the absolute tops of these parabolic moves are impossible to predict, both on a time and price basis. The coming bond collapse will resemble the Sack of Rome.