Only 13 Weeks til the Bond Markets Crash?

When the sell-off starts it will cause a panic. And markets are especially vulnerable at the end of a quarter...

SINCE NOVEMBER last year, the US Federal Reserve has been buying US Treasury bonds at a rate of about $75 billion a month, writes Martin Hutchinson, contributing editor at Money Morning.

That's part of Fed Chairman Ben S. Bernanke's "QE2" program, under which the central bank was to buy $600 billion of the government bonds.

But QE2 ended on Thursday, meaning the Fed will no longer be a big buyer of Treasury bonds.

So starting Friday, the US Treasury needs to sell twice as many Treasury bonds to end investors as it had been.

But the problem is, who's going to buy them?

Not China, which is diversifying its trillions in assets to get as far away from the US Dollar as fast as it can.

Not Japan, which is trying to rebound from its March 11 earthquake, tsunami and nuclear disaster – and is focusing all its spending on reconstruction.

And – as we've seen –neither is the Bernanke-led Fed.

I'm telling you right now: We are headed for an epic bond market crash. If you don't know about it, or don't care, you could get clobbered.

I'm an old bond-market hand myself – my experience dates back to my days at the British merchant bank Hill Samuel in the 1970s – so I see all the signs of what's to come.

Having the two biggest external customers of US debt largely out of the market is a huge problem. Unfortunately, those aren't the only challenges the market faces. The challenges just get bigger from there – which is why I'm predicting a bond market crash.

Steadily rising inflation is one of the challenges. Inflation is a huge threat to the bond markets, and is almost certain to create a whipping turbulence that will ultimately infect the stocks markets, too.

Many pundits will tell you that if investor demand for bonds declines, and investor fear of inflation increases, bond-market yields could increase in an orderly fashion.

But I can tell you that the bond markets don't work like that. Price declines affect existing bonds as well as new ones, so the value of every investor's bond holdings declines. And with many of those investors heavily leveraged – especially at the major international banks – the sight of year-end bonuses disappearing as bonds are "marked to market" will cause a panic. 

That's especially true when end-of-quarter or end-of-year reporting periods loom.

That's why we can expect a bond market crash at some point. If you ask me to make a prediction, I'd say that September or December were the most likely months for such a crash.

One sad – even scary – fact about what I'm predicting is that Fed Chairman Bernanke won't be able to do much about it ... though he'll certain try.

Consumer price inflation is now running at 3.6% year-on-year while producer price inflation is running at 7.2%. In that kind of environment, a 10-year Treasury bond yielding 3% is no longer economically attractive. Since monetary conditions worldwide remain very loose, inflation in the US and worldwide will trend up, not down. 

The bottom line: At some point, the "value proposition" offered to Treasury bond investors will become impossibly unattractive. When that happens, expect a rush to the exits. 

If Bernanke attempts "QE3" – a third round of "quantitative easing" – he will have a problem. If other investors head for the exits, Bernanke may find that the US central bank is as jammed up as the European Central Bank (ECB) currently is with Greek debt: Both will end up as the suckers that are taking all the rubbish off of everyone else's books.

There's a limit to how much Treasury paper even Bernanke thinks he can buy. And if everyone else is selling, that "limit" won't be high enough to save the bond market.

With Bernanke buying at a rapid rate, the inflationary forces will be even stronger, so every Bureau of Labor Statistics report on monthly price indices will be marked by a massive swoon in the Treasury bond market.

Eventually, there has to be a new head of the Fed – a Paul A. Volcker 2.0 who is truly committed to conquering inflation. Alas, it won't be Volcker himself since, at 84, he is probably too old. 

But it might be John B. Taylor, who invented the "Taylor Rule" for Fed policy. The Taylor Rule is actually a pretty soggy guide on running a monetary system. But it has been flashing bright red signals about the current Fed's monetary policy since 2008.

However, since a Fed chairman who is actually serious about fighting inflation would be a huge burden for current US President Barack Obama to bear - and could badly hamper his chances for re-election, any such appointment is unlikely before November 2012.

Given that reality, it's likely that Bernanke will attack any bond market crash that occurs ahead of the presidential election just by printing more money; there won't be any serious attempt to rectify the fundamental problem, meaning inflation will continue to accelerate.

This would be very good for gold and other hard assets, but challenging for Treasury bonds, as prices will remain weak no matter how vigorously Bernanke attempts to support them. 

If Bernanke were not around, I would actually expect Gold Prices to fall following a bond market crash. But since he's still at the helm at the Fed, I expect him to do "QE3" in the event of a crash. And that means gold – not Treasury bonds – would become an investor "safe haven."

You can expect Gold Prices to zoom up, peaking at a much higher level around the time Bernanke is finally replaced. 

Silver will also follow this trend. So make sure you have substantial holdings of either physical gold and silver or the exchange-traded funds (ETFs).

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