The Most Dangerous Bubble of All

If you agree that the tech bubble of the 1990s and the housing bubble of the 2000s were extreme, then you must not ignore a bubble that could be the most dangerous of all — grossly overvalued bonds.

That’s precisely the bubble we have right now! And in just a moment, I’ll tell you why it’s going to bust. But first, consider …

The Swift and Certain Impacts Of ALL Bond Market Busts …

Let’s say I pay $10,000 for a $10,000 face value bond paying 5 percent. I earn $500 in interest each year. No more, no less.

Now let’s say the price of that bond plunges to $5,000. If you buy it at that price, you still get $500 in yearly interest.

But all you’ll have to invest is $5,000. So your interest yield is not 5 percent. It’s 10 percent! The price of the bond falls in half; the yield doubles!

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In fact, the price and the yield of a bond are really two ways of measuring the same thing — much like a cup 3/4 full is the same as a cup 1/4 empty.

So when the bond market bubble busts, the inevitable and immediate consequence is that interest rates surge — not only on bonds, but also on mortgages, auto loans, business loans, and almost every kind of financing imaginable.

If you hold fixed-income investments locked in at today’s low interest rates, you will almost definitely get hurt, regardless of what kind you own — Treasury bonds, Ginnie Maes, municipal bonds, mortgage bonds, corporate bonds, long-term bank CDs, plus many kinds of life insurance policies and annuities.

Either …

* You’ll get stuck with miserable, below-market yields for years tEo come, or …
* You’ll have to pay a tremendous price — losses in principal and/or stiff penalties — to switch to higher yielding investments.

Not a pretty picture!

On the flip side, though, you will also have the potential for large profits with a relatively high level of certainty.

How?

Well, years ago, it would have been very difficult or very risky. You’d have to be a government security dealer trading tens of millions of dollars. Or you’d have to get involved in futures contracts.

Today, fortunately, you can profit from rising interest rates with simple exchange-traded funds (ETFs) that any investor can buy in any standard brokerage account, online or offline. The more bond prices go down — and rates go up — the more you stand to make.

This is why Safe Money editor Mike Larson has been recommending these ETFs continually, and they’re starting to pay off.

TBT chart

Take TBT, for example.

For most of last year, this ETF didn’t do well — it fell in value because long-term Treasury bond yields were still going down.

But since September 2010, when those yields began to rise virtually nonstop, TBT has been going up in tandem — also virtually nonstop.

Moreover, it’s designed to rise at TWICE the pace of the move in the bond market:

If Treasury bond prices fall by 10 percent, this ETF is designed to rise by 20 percent. And that’s precisely what it has done — or better — in the past few months!

Why the Bond Market Is Undeniably a Bubble

The most obvious, telltale sign of a bubble is when asset prices are artificially driven higher by misguided government supports, subsidies, bailouts, or sheer greed and stupidity.

That was certainly the case of the housing bubble.

It was also true for some of the greatest bubbles in history — the Dutch Tulip Mania in the 17th century, the South Sea Bubble of the 18th century, the stock market bubble of the 1920s, plus many others.

And it’s definitely the case here — not only in recent years, but going back for over a decade.

In fact, since the year 2000, one of the most frequently used — and abused — policy tools of the Federal Reserve has been to cut rates and artificially bubble up bond prices.

* The Fed cut interest rates and supported bond prices to fight the technology bust, the 9/11 aftermath, the housing bust, the mortgage meltdown, the credit crunch, and the debt crisis.
* The Fed did it again to help avert deflation, debt defaults, and other disasters. And …
* The Fed is still trying to do it AGAIN now, but with a big difference: Its bond-market buying binge is finally starting to backfire.

The facts supporting this thesis are undeniable and speak for themselves:

* In the early 2000s (starting January 3, 2001), the Federal Reserve lowered short-term interest rates 13 times, to 1 percent, and then sat on them at that level for 12 months.
* In the late 2000s, when the financial crisis struck the world, the Fed did it again, lowering short-term rates nine times to virtually zero.
* And starting more recently, when the Fed ran out of room to lower short-term rates, it targeted long-term interest rates — by running the printing presses and buying up even more bonds.

The consequence is also undeniable: The biggest bond market bubble of all time. The only remaining question is …

What Will Trigger a Bond Market Bust?

Take your pick (one or more) …

Trigger #1. Inflation and Inflation Fears. Inflation has been so low for so long, that the complacency on Wall Street and Washington is bordering on the pathological.

Here we are — with massive surges in the price of gold, silver, agricultural commodities, and now, energy to boot — but STILL most bond investors, including the “smartest” banks and insurance companies, don’t seem to bat an eyelash.

Here we are — with money supply and inflation surging in China and other emerging markets — and again, virtually no one seems to care.

These price surges are bound to pop up in the U.S. producer and consumer price indexes, which investors DO pay attention to. And when they do, an instant bond market bust is a likely outcome.

Trigger #2. Deficit Inaction. When the Congressional Budget Office recently announced that THIS year’s deficit would hit nearly $1.5 trillion, bond prices fell and interest rates rose.

Bond investors knew that the Treasury would have to issue huge new supplies of bonds to finance the deficit. And they knew that big new supplies equal even bigger price declines.

What happens if the deficit balloons to $2 trillion? Another big decline in bond prices!

And what if Obama and Congress continue do little or nothing to make good on their promises of deficit reduction? Still MORE steep price declines!

Trigger #3. Dollar Collapse. Three out of every five dollars financing the U.S. federal deficit now come from foreign investors. Only two out of five come from domestic investors (other than the U.S. government itself).

Heck, the last time America was so dependent on foreign money, Benjamin Franklin was sailing to Paris to beg the French to help finance the Revolutionary War!

What happens next? As long as those foreign investors believe they’ll be paid back in dollars that are worth something, they may hang on.

But as soon as they see the value of their dollars collapsing, the only rational response is to dump their holdings — driving bond prices down and interest rates skyward.

What if the economy sinks? Will that save the bond market?

Before he passed away, my father, J. Irving Weiss, who lived through — and even predicted — the Great Depression, answered a similar question in a very unique way. Here are key excerpts from his manuscript of the subject …