Thursday, December 23, 2010

US Treasury and Municipal Bonds are losing values. Dangers ahead...By Shan Saeed

Yield curves are the powerful indicator of the future. By Shan Saeed

This is the most important development since November-2010 in the US financial history. Long long-term U.S. Treasury bonds have fallen 7% in value. That's not supposed to happen. But it's happening. Municipal bond market has fallen 6%. That, too, isn't supposed to happen. But it's happening at a precarious time of the global financial turmoil.

For most of the last century, the whole world has believed the obligations of the U.S. government – and the obligations of thousands of states, cities, towns, and other municipalities in the U.S. – were the safest investments in the world. These "safe" investments aren't supposed to crash. The reason U.S. Treasurys and municipal bonds are crashing is by far the most important financial development of 2010. The crash has affected and will continue to affect the value of every stock, bond, exchange-traded fund... every type of investment there is.

If you've already looked for the reason bonds are crashing, it hasn't been hard to find. The reason bonds were crashing was on the front page of all the major financial websites. It's been there since November 3, when the Federal Reserve announced it would print $600 billion between now and June 2011 and buy Treasury bonds with it.

First week of November-2010, newspapers were hot. Headline from

1. Financial Times' website read, "Fed maintains asset purchase plan"
2. The Wall Street Journal's website read, "Fed Sticks To Bond-Buying Policy."
3. And Bloomberg's site read, "Fed Retains $600 Billion Bond Buying Plan to Boost Economy.

It all means the same thing: The Federal Reserve will keep printing money. QE2 will go global with countries getting enamored of BEN BENANKE latest escapade. ECB, BOE, BOJ will increase monetary base to buy bonds and long term assets to keep their economies moving. US dollar will continue to get weaker. The bond market will continue to fall. Interest rates will continue to rise. Yield would go up. Watch out for US dollar bubble and Government debt bubble. Make no mistake about it — the Obama administration is embracing massive inflationary deficit spending. Ben Bernanke has released unheard of measures of "quantitative easing" — intentionally devaluing the dollar as a risky gamble to restart the economy. In the meantime it has only eroded the value of your savings and decreased the returns you can get on safe investments like CDs, Money Market accounts, and bonds. President Obama has committed the government to at least $7 trillion in new spending and warned the American people to expect trillion-dollar deficits for the foreseeable future.

Decades ago, Famous Nobel laureate from Uni. of Chicago Milton Friedman answered these questions clearly and precisely in his insightful book, Money Mischief: Episodes in Monetary History. In Money Mischief, Friedman even warned that the coming inflation could "destroy" US economy. Furthermore, he wrote: "Inflation is a disease, a dangerous and sometimes fatal disease that, if not checked in time, can destroy a society." [Money Mischief, Page 191]

You see the end result of that process in countries like Zimbabwe today, where prices double every day, and it now takes a $10 billion Zimbabwe note to buy a single loaf of bread - assuming you can find one.

Could America suffer the same fate? Friedman wrote ominously, "The fate of a country is inseparable from the fate of its currency." He shared his strategy how the U.S. and the West could still avoid hyperinflation, even with unbacked paper currency.

Fortunately, the bond market remains more-or-less immune to swings in
policymakers need to justify their action in whatever language the
current times demand. The track record of the yield curve as a
predictor of future growth is more-or-less perfect, especially in the
United States.

Why is it that the yield curve is such a powerful predictor of the
future? Because the spread between short rates and long rates
basically dictates the profit margin of banks: the cost of funds is
basically the deposit rate paid to customers, while those deposits are
invested in longer-term loans and mortgages to the private sector, or
bonds purchased from the government. Simply put: the wider the gap
between short rates and long rates, the bigger the profitability of
the banks, and the bigger the profitability, the more eager they get
to lend, which in turn makes it easier for private entrepreneurs or
households to borrow. The rise in leverage creates growth as people
build new homes, companies invest in new factories and employ more

Conversely, when the curve flattens, the cycle goes into reverse:
banks’ profitability drops, they become less eager to lend, credit
begins to slow down etc. An inverted curve is the extreme case: now
banks lose money on their basic business, so the contraction cycle
goes into overdrive. So, by flattening the yield curve, the Federal Reserve
is now following directly in the footsteps of the Bank of Japan, in my
personal view. It is risking a significant and possibly permanent
decline in the future growth rate of the economy: flattening the curve
by buying treasuries, central banks remove the incentive for long-term
risk taking. Long-term investment becomes less attractive and leverage
ratios decline. is the USA heading for LOST DECADE like Japan seems likely?

Moody's Investors Services publishes bond ratings. A low rating means a bond is more likely to default. A high rating means a bond is unlikely to default. The highest bond rating is triple-A. During the financial crisis in 2007-2009, Moody's damaged its credibility by giving junky mortgage securities the coveted triple-A rating. Now it's desperate to get some of that credibility back.

U.S. Treasury bonds are rated triple-A, the highest rating there is. But that might be about to change. Moody's doesn't like the implications of the new $858 billion tax cut deal worked out between President Obama and Congress. Recently, Moody's said, "Unless there are offsetting measures, the [new tax] package will be credit negative for the U.S. and increase the likelihood of a negative outlook on the U.S. government's triple-A rating during the next two years."

That means Moody's is thinking about lowering the U.S. government's triple-A rating. The lower your credit rating, the higher the interest rate you have to pay on your debts. The U.S. has about $14 trillion of debt. If interest rates go high enough, it could bankrupt the country. As usual, the American ratings agencies are late to the party. U.S. Treasurys have already been downgraded to double-A by analysts in two of the largest, fastest-growing emerging economies in the world: China and Brazil.

Brazil's economy is larger than all other South American countries combined. It's an important trade partner with the U.S., China, and many other countries around the world. What Brazil thinks of the U.S. government's credit rating is important.

China is the largest holder of U.S. Treasurys. It has no economic incentive to allow U.S. Treasurys to be downgraded. But it can't afford to ignore reality, either.

Just weeks ago, China and Russia announced they would no longer use U.S. dollars in their trading with one another. In 2010, the Bank of China reported a doubling of its gold holdings. Right on the cover of the November 8 issue of Barron's magazine, an ominous subhead reads, "With the dollar more vulnerable, China for the first time is investing more overseas in hard assets, like copper, oil, and iron, than in U.S. government bonds."

That's not what you do if you believe in the ultimate safety and sanctity of the U.S. government's credit rating. When foreigners start questioning the credit rating of the United States, they're essentially rejecting the U.S. dollar. It's as if a billion Coke drinkers have suddenly decided they're better off with orange juice. Imagine what would happen to Coke's stock and bonds...

In short, the jig is up. The world knows the Federal Reserve is compromising the country's credit rating. The more money the Fed prints, the higher the interest rate bond holders will demand to compensate them for the risk taken, the lower bond prices will fall.

Bonds crisis is ominous and risky. Investors should consider off-loading some of their bond investments which face the same problems as Treasurys and municipal bonds. When interest rates rise, these investments decline in value. If you're an income-focused investor, I urge you to focus on dominant dividend paying companies instead. Buy Gold and Silver to get insurance of your wealth. Real Assets are here to stay. Stocks can go down to zero but not commodities. Invest in Copper, Oil, Gold and Silver...Remember COGS

Disclaimer: This is just a research piece and not an investment advice. Investors are highly encouraged to execute their own due diligence for their investment strategy and decision.

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