Gold Up, Bonds Up...?

Buying Treasury bonds is like buying a lead life jacket. What investors need is a gold parachute...

A DEAL IS CLOSE on the Washington stimulus. Stocks bounced, but gold was up more on Wednesday, hitting a seven-month high of $944.50 an ounce, notes Dan Denning for The Daily Reckoning Australia.

Ten-year US Treasury bond yields, however, are coming down as investors lose confidence in new US Treasury secretary Tim Geithner's plan, pushing prices higher in a "flight to safety".

Yes, it's really weird that the US government can successfully auction $21 billion in ten-year notes at the same time it plans on growing its annual deficit by $1.5 to $2.5 trillion. But it's a weird world we live in. Foreign central banks snapped up 38% of the auction, according to Reuters.

This is like buying a lead life vest as your ship goes under the waves.

This week alone, the Treasury is hawking $187 billion worth of US government debt. That's ambitious. Most of it, though, is shorter-maturity notes and bills. Only $14 billion in 30-year bonds will be auctioned. Meanwhile, $32 billion in three-year notes is up for grabs to the highest bidder.

The good news for Team America is that Treasuries are joining gold as a safe haven asset. Investors are growing more convinced that the banks are simply lying about future losses they know they'll have to take. The banks don't want to sell impaired assets at a loss. It would force them to ask for more government capital with strings. Or, it would make them insolvent.

So Treasuries go up. Because the government can't default on its debts. Right?

But the bad news is that yields are slowly creeping up too. The three-month yield is now at 1.41%, paltry and risible but the highest it's been since November. Okay, bond yields are an extremely boring subject, but if you look at the composition of America's publicly traded debt, more and more of it has shifted to the short-end of the interest rate curve, 2-year, 5-year notes and 10-year notes. So if you get a sudden spike in market interest rates, the cost of these monthly auctions – and there are going to be a lot of them this year and next – goes dramatically up for Uncle Sam.

Dig deep oh taxpayers!

What would cause a sudden spike in interest rates? It's not what, it's who – the bond vigilantes! That's the media name for those bond traders who first pushed US yields above double digits at the start of the 1980s, and then scuppered Bill Clinton's big spending plans during his first term.

Back then, the market was capable of imposing some fiscal discipline on the US government by forcing it to pay higher rates of interest for the debt it sold to finance its spending plans.

Today, those spending plans are much larger. The government is not behaving in a fiscally disciplined way. But the bond vigilantes are at war with the equity nervous nellies. That is, the shock and dread of higher inflation that would normally accompany such big spending plans and send rates higher is at odds with the paralyzing fear that owning stocks is an even bigger risk than owning US Treasury bonds and notes.

Maybe this was Geithner's plan all along. Drag his feet on the bank plan to maintain the foreign bid on US debt. Sell the debt to finance the stimulus, then screw the bondholders later when you have to monetize the debt to finance the aggregator bank. Hey, it's not so unlikely is it?

Reuters reports, meantime, that "The Bank of England will probably have to ease monetary policy further to get the economy growing again, and could start buying gilts as soon as next month to achieve that, Governor Mervyn King said on Wednesday."

Such Quantitative Easing – whether in the UK, US, Europe or Australia – would mean pure money printing. The central bank prints money to buy government debt. Someone has to buy that debt, you know! And if no one in the marketplace is going to do it, in steps the central bank.

This is a recapitulation of the strategy in Japan that failed. It's also a preview of what the US will probably do as well. The government is pouring trillions into the sinkhole of a decade's worth of bad investment in residential housing. All that money – which is capital not going to the private sector, remember, not building tomorrow's factories and not creating tomorrow's jobs and not paying tomorrow's incomes – is borrowed from the future. The interest on it will have to be paid with higher taxes. And inflation.

What is the government about to do to our money? If there is a "golden parachute" in the coming inflationary crisis, it's going to be in the metals that have historically been money. The Gold Bullion angle is well covered, but now brokers and talking heads are talking up gold, that's worrisome in the short-term.

It means you could see a big spike up in gold back to $1,000. And then? Profit taking is our guess. Swift and sharp.

That doesn't change our long-term outlook at all. But just keep in mind that any time you get this much momentum, it's bound to exhaust itself. You'll get a shakeout, a consolidation, and, if we're right, a resumption of the long-term trend higher.