Eric Roseman's Eruptions: Stocks, Global Markets and Commodities BLOG

One Last Hurrah for Treasury Bonds

Montreal, Canada

The bull market in Treasury bonds since 1982 is heading into the bear's digestive system over the next 12-24 months. Some of the shrewdest investors, including Tiger Management founder, Julian Robertson, Jr, have begun to initiate bets against U.S. Treasury bonds in anticipation of higher interest rates (See October 20, 2009 blog on Julian Robertson, Jr.).

Unprecedented global government fiscal spending, quantitative easing, bulging budget deficits – even in Germany – and expensive entitlement and social welfare programs all promise to drive yields much higher in the West eventually. The cost to finance these and other financial time-bombs promises to become more expensive in the age of the super debt cycle and its near collapse in late 2008.

The cost of funding long-term government social welfare programs alone far exceeds the current revenue generated by the IRS. Some sort of entitlements crisis lies ahead.

But a bigger threat looms for U.S. Treasury bond investors – China.

The Chinese are up to their eyeballs in Treasury debt and U.S. dollars with the bulk of their mammoth $2.2 trillion dollars of reserves in American dollar-denominated paper. As Julian Robertson proposed last month it seems almost absurd for the Chinese to continue funding America's trade and budget imbalances if the dollar continues to decline. It also seems stupid for China to accumulate more Treasury bonds in the face of rising supply over the next two years – and the likelihood of higher long-term interest rates to draw international Treasury financing. Higher rates result in lower bond prices.

Yet if the ongoing inverse relationship between stocks and bonds continues into the next stock market sell-off, bonds might surprise everyone with another big rally. That's what the world's biggest bond fund complex is betting on.

Since 1997, Treasury bonds have been one of the few safe-havens amid systemic crisis or a stock market meltdown. After plunging last fall after Lehman Brothers failed, Treasury bond yields hit overbought levels and have ratcheted higher this year to 3.38% this morning compared to 2.25% on December 31 when the financial system was approaching the proverbial cliff.

Bill Gross, probably the smartest fixed-income advisor in the world under PIMCO, recently loaded-up on long-term Treasury debt in September; Gross believes long-term rates will decline under the weight of a double-dip economic recession in 2010 or 2011. The bond bull has made some savvy calls in his lengthy career and even amid a decline in Treasury bond prices this year Gross's PIMCO Total Return Fund is up 14%.

Longer term, I can't find a single reason to own U.S. or European government debt.

Deficits are likely to remain a constant theme for years and in the United States might drown the government as interest costs head through the roof – currently about $200 billion dollars. Mathematics 101 tells you this relationship can't last forever. We also can't expect the Chinese to fund these deficits indefinitely.

Before heavily shorting Treasury bonds, however, consider buying long-term Treasurys. That might be the next great trade for 2010. It's also one of the few assets that remains highly contrarian and unloved by the investment herd.

Bill Gross has rarely been wrong. If you believe, like I do, that the stock market won't continue to advance forever -- up almost 64% since March – then 30-year Treasury bonds are a great speculation right now. Inflation is non-existent, nobody is raising prices and credit intermediation is years away from recovering – especially in the absence of federal assistance.

Time for bonds?

U.S. Retail Investors Follow Central Banks in Bond-Buying Frenzy

Montreal, Canada

When it comes to market-timing, central banks take the booby-prize for buying or selling assets at the absolute worst moment. And retail investors are following them to the edge of the cliff.

Ten years ago, central banks –excluding the United States and Germany – sold piles of their gold stash at around $250 to $300 an ounce. Turn the clock ahead ten years and gold prices have more than quadrupled. Also in 2000, big banks in the Persian Gulf began dumping foreign currencies for U.S. dollars – about 18 months or so before the dollar peaked.

What are central banks doing now?

Some of the world's largest and most influential central banks are aggressively buying their own debt. Coined "quantitative easing" this practice entails purchasing your own paper in order to keep yields down amid a deluge of bond issuance to finance bulging deficits. This is especially the case in the United States and the United Kingdom – home to incredibly reckless fiscal deficits. Considering it's "inflate or die" for the Western economies, buying bonds at these levels has to be regarded as one of the dumbest moves in the history of central bank policy initiatives.

At some point in the near future – barring an outright economic depression – long-term interest rates must rise. And as rates begin to rise, the long end of the yield curve in the United States and Europe will steepen as investors demand a higher risk premium for holding government paper.

This is already happening in Australia after the Reserve Bank hiked lending rates to 3.25% recently. Australia, by the way, didn't suffer a banking collapse and didn't have to raise hundreds of billions of dollars to finance deficit spending; yet the market has taken short and long-term rates sharply higher since late September resulting in a slaughter for bond investors.

One can only imagine what lies ahead for bond markets in the quantitative easing camp.

In the United States, mutual fund investors have occasionally ranked among the worst in market-timing. For example, the bulk of equity fund flows in the 1990s bull market occurred mostly in the last 24 months of that spectacular "bubble" as investors chased technology stock funds.

Yet for the first time in 2009 U.S. retail investors placed fresh capital into stock funds after selling these assets all year. U.S. stock funds have witnessed net outflows every month this year, except in August. About $14.4 billion dollars has been redeemed by U.S. investors in stock funds in 2009.

It's important to gauge what retail investors are doing because they currently hold about $3.3 trillion dollars parked in near-zero percent yielding money-market funds – representing about 30% of the U.S.'s entire stock market capitalization. That avalanche of cash is nervously sitting earning almost nothing as stocks zoom ahead since March. Still, a record $395 billion dollars has poured out of money-market funds since January.

So where are retail investors taking the plunge this year?

Bond funds. According to the Investment Company Institute, sales of U.S. bond funds hit a record $220 billion dollars through August while equity sales remain negative or in net redemption. That tells me that investors are chasing things like corporate bonds, high-yield debt and anything with a coupon attached to it to supplement a string of post-2007 stock market nausea and since late 2008 – almost zero percent interest rates on cash and T-bills.

The history of retail mutual fund investors and central banks is a sad tale. Both investor types typically sell near a low and buy close to a market top. It looks like it won't be any different with bonds going into 2010 as both investor classes are loaded to the gun-wells in fixed-income.

U.K. Gilts the World’s Best Short

Montreal, Canada

Judging by the break-even rates on inflation-protected bonds, the United Kingdom is home to the highest future inflation. And that means shorting or betting against British gilts (government bonds) will probably rank as one of the smartest speculations over the next five years.

 

30 Year Gilt Price Chart (Financial Times)

Long-term break-even rates for U.K. TIPS in 2035 show a 3.4% inflation rate – the highest in the G-10. This compares to 2.2% for U.S. break-even rates maturing in 2039.

Earlier this week I reported on Julian Robertson, Jr. and what the hedge fund legend believes is the greatest short – long-term U.S. Treasury bonds ahead of a credit debacle triggered by possible Chinese asset disposals. Robertson warns if the Chinese dump T-bonds we'll suffer a global financial Armageddon.

The Chinese have been especially vocal about surging U.S. deficits since last year and have repeatedly warned they are unsustainable; as America's largest financing nation they have also asked Treasury for some sort of guarantee on Treasury bonds. China owns approximately 40% of all outstanding U.S. Treasury supply – or more than $1 trillion dollars.

If U.S. Treasury bonds are an ideal short than Britain's bond market is probably an even better speculation on the short side. England is amassing piles of debt.

The U.K.'s financial system is essentially bankrupt. In 2008, the aggregate cost of bailing-out its banks exceeded the entire value of England's gross domestic product. The government already owns most of the country's largest banks – including Royal Bank of Scotland and Lloyd's.

Quantitative Easing (QE), the central bank codeword for massive credit expansion, is no greater anywhere than in the United Kingdom whereby the Bank of England's planned $287 billion dollar bond purchases has triggered rising inflation fears; the central bank has been an aggressive buyer of British gilts since last fall – especially longer dated gilts.

The big question for gilts is what happens once the Bank of England terminates or slows its QE program? Who will absorb this supply?

The odds are pretty high that Britain will have a hard time finding buyers to finance its ballooning budget deficits. That scenario, which is highly likely down the road once deflation is defeated, implies a major funding crisis coupled by sharply higher interest rates. The pound is also vulnerable and needs to remain at a low level in order to defeat deflation.

The above scenario, by the way, is also likely to play out in the United States eventually. Both Anglo-Saxon economies represent the worst long-term inflation scenarios and shorting their respective government bonds ranks as one of the greatest speculations over the next decade.

Hedge Fund Master Bearish on U.S. Treasury Bonds

Montreal, Canada

"It's almost Armageddon if the Chinese and Japanese don't buy our debt."

    -- Julian Robertson, Jr., CNBC interview, September 2008.

Ten years ago a multi-manager hedge fund I advised for a British institution owned the Jaguar Fund – managed by legendary manager, Julian Robertson, Jr. No other position in that fund was more profitable from 1996 to 2000. Tiger, the asset managers behind Jaguar, began with just $8 million dollars under management in 1980 and peaked north of $22 billion in the late 1990s.

Until 2000 when he closed shop, Robertson, 76, was the ultimate macro hedge fund manager – probably equal or better than George Soros. The Tiger Funds slugged out more than 20% per annum from 1980 until 2000. In late 1999, Robertson closed his funds following steep losses shorting technology stocks – just months ahead of the peak for the NASDAQ.

Julian Robertson now manages his own money and helps to seed promising hedge funds. He has a sharp understanding of the global economy, the primary trends driving capital markets and believes this recession will be long and painful (http://www.businessinsider.com/julian-robertson-inflation-could-hit-15-20-2009-9).

 

Robertson's chief concern now is the level of U.S. deficits and its reliance on China to continue funding America's budget gap. He remains under-weighted in stocks.

"I prefer to run scared through here. I think that if the Chinese stop buying our debt, it is virtually the end of the financial world as we know it. The conventional thinking is that they will continue buying. But I don't think it's logical to assume somebody will continue to buy paper which declines in value. Our dollar is declining in value, and it's been pretty shocking over the last four or five months," he lamented in an October 16 interview with the Financial Times.

Asked about his current strategy now, Robertson confessed he doesn't particularly like stocks (he owns Apple, Visa and Mastercard) but prefers to short long-term Treasury bonds: "There are insurance policies that are worth considering. My favorites are Curve Caps, basically a "put" on long-term bonds five years out from now. If we do have inflation, long-term yields will have to go way up, which means the bonds will go way down, and the Curve Cap will be a terrific investment."

Betting against a disaster – if the Chinese and perhaps the Japanese bail on U.S. Treasury bonds – has never been easier. Two reverse bond ETFs now trade in the United States.

The Ultra Short 20+ Year Pro Shares Fund (NYSE-TBT) shorts long-term Treasury bonds. Though a volatile trade, it might yield enormous profits if long-term rates climb sharply higher over the next few years.

Robertson's macro view highly conflicts with PIMCO's interest rate forecast.

PIMCO's Bill Gross recently loaded up on long-term Treasury and mortgage agency debt in September anticipating a double-dip economic recession in 2010 – contrary to what Robertson is expecting. But if the Chinese balk at funding bulging U.S. deficits the Panic of 2008 will turn out in retrospect to be a picnic.

Convertible Bonds Lead the Way in 2009

London, England

Since the beginning of the year I’ve largely avoided common stocks and instead have favored high quality bonds and convertible bonds. Though bonds have lagged behind stocks since March 9, they’ve also produced the same returns or better in 2009 with far less risk and volatility.

Basically, I still don’t like earnings prospects and prefer to get paid to sit tight. Bonds provide that option.

Investment grade debt, as measured by the Barclays U.S. Corporate Bond Index, has gained 12.4% this year as yields on this benchmark touch pre-Lehman Brothers bankruptcy levels at just 5.47%; back in September those same bonds yielded 9.09%. And BBB-rated bonds – the lowest caliber of investment grade paper – have surged 20.5% this year.

Convertible bonds, however, have been absolutely terrific since hitting a multi-year low late last year following a collapse in the sector. By October 2008, convertibles were trading at their most attractive levels since 1994 following a massive exodus by hedge funds as convertible arbitrage strategies hemorrhaged. Convertible bonds have rallied more than 20% in 2009 – far ahead of the S&P 500 Index.

Another segment of credit I’ve also aggressively purchased since last December is TIPS or Treasury Inflation-Protected Securities – up about 6% this year even amid deflation in CPI or the consumer price index.

TIPS are the only bonds I’d be buying at this point. The entire gamut of fixed-income and hybrid bonds (convertibles, preferreds) have soared over the last five months and investors would be prudent to wait for a correction before committing new funds.

TIPS are still cheap with ten year break even rates showing a 1.94% annualized inflation rate from now until 2019; it’s highly unlikely U.S. CPI will trade below 2% over the next decade with a flood of money creation underway since last year and the deluge of Treasury supply required to fund deficits over the next several years.

The United States and other countries tied to the dollar will suffer the worst inflation debacle since the 1970s once we conquer deflation; monetary policies virtually everywhere are highly inflationary and the odds of the Fed successfully draining all of this massive excess liquidity to avert inflation is next to nil. Its track record since 1913 has been incredibly poor as an inflation fighting central bank.

It’s also instructive to mention that China has started purchasing TIPS after requesting more supply from Treasury recently.

Why anyone would want to buy nominal Treasury bonds – vulnerable to long-term inflation – is beyond me. But TIPS at least give you future inflation protection and the Chinese, whom are stuck with dollars, are beginning to redirect their recycled trade balances into TIPS.

I’m off to Oslo tonight. Have a good weekend.

The Beginning of the End for Treasury Bonds

Montreal, Canada.

The United States, like several other European governments, is struggling to sell a truckload of Treasury’s this year. Investors are advised this slow bleed can easily magnify into a full-blown crisis over the next few years if the global economy fails to recover.

From 1981-82 until December 2008 Treasury bonds enjoyed a secular bull market as interest rates collapsed from a Volcker Fed peak of 20% in 1981 to 2.25% in December last year. Zero-coupon bonds – long-term bonds on steroids – have earned big double-digit gains over the last 28 years as rates tumbled handily outpacing most global stock markets.

But the big bond bull market is over. Faced with an unprecedented funding gap amid the worst credit collapse since the 1930s and plunging tax revenues, the United States is now issuing more debt than ever to finance its expenditures. About $2 trillion dollars is estimated to be auctioned this fiscal year. And what it can’t finance, Treasury simply monetizes the debt vis-à-vis the Federal Reserve, or coined “quantitative easing.” Several other central banks are doing the same thing this year, including the Swiss National Bank and The Bank of England.

Yet nobody has the debt the size of America’s. Deficits are clearly out of control with no political resolve to reduce spending. At some point, a major lenders’ strike looms as foreigners balk at financing this paper forcing the United States to perhaps impose a deficit-financing tax or a VAT consumption tax to finance its explosive debt and the interest required to service outstanding Treasury bonds.

The Chinese are stuck with about 40% of this paper, the Japanese about 25% and the British about 10%. Rightfully concerned, the biggest holders of U.S. Treasury debt outside of Japan and England have increased their rhetoric lately as they grow nervous about their declining dollars. The Chinese and the Russians are the most vocal, fed-up with dollar depreciation.

Yesterday, Treasury was successful in selling its tranche of seven-year Treasury bonds. But for the second time this week Treasury attracted poor demand for the sale of five-year and two-year notes. That raises the cost for Treasury as it relies on the Fed to absorb unwanted notes.

If you need to park short-term funds then avoid longer dated notes. In fact, I’d be shorting or betting against 20-year and 30-year Treasury bonds. Stick to the short end of the yield-curve or bonds maturing no later than in 2011-2012. That’s what PIMCO is doing now.

On Tuesday, Treasury suffered its worst five-year auction in history. Yet that news barely makes a headline. It’s not the first time Treasury has struggled to sell its paper and it’s certainly not alone; the Germans, among several other Euro-zone credits, have struggled to auction their debt since last October with four failed or reduced bond auctions. That’s almost mind-boggling because I’d consider the Germans the best government credit in the world, possibly along with the Swiss and Norwegians.

Failed bond auctions in the West since October mark the beginning of the bear market in government bonds. Assuming we don’t slip into a deeper recession or worse, the bond market is the worst place to park long-term funds ahead of the next inflation crisis down the road, a dollar and EUR blow-up and, eventually, higher interest rates to support ever-growing government borrowing.

Have a good weekend. See you on Monday.

“Bubble” in Junk Bonds Defies State of Credit Expansion

Montreal, Canada.

Since March credit spreads on the most speculative debt have crashed to their lowest levels since the Lehman Brothers bankruptcy in mid-September. High-yield or junk bonds now yield 12.60% compared to a post-Lehman Brothers bankruptcy high of 22.49% in October. And since the stock market lows on March 9 junk bonds have skyrocketed more than 55%.

Junk bonds are the best-performing segment of credit in 2009 showing a dizzy 32% gain, according to the Merrill Lynch Bank of American High-Yield Constrained Index. That easily outpaces the fixed-income competition. Other high-yield indices have surged as much as 55% this year as investors lunge after risk again following a huge 25% crash for the sector in 2008. High-yield mutual fund inflows are also ballooning again since April as investors shove billions into below investment grade bond funds.

This party is probably home to the next crash in global markets. Yes, credit markets have already collapsed since late 2007-2008; but the junk bond market has no business trading at these absurd levels ahead of rising defaults over the next 12-18 months while cornered by an environment of tight credit in the United States and Europe.

Unlike previous economic recessions, when riskier assets like junk bonds offered smart calculated speculations, this cycle is unlike anything we’ve seen since the 1930s. Yet investors continue to underestimate the risks lured by fat yields and the historical crash in values in 2008. Only the shrewd or lucky ones will sell into current market strength; most junk bond investors will hang onto their mutual funds and eventually get cleaned out when the next bear market ravages this sector.

Junk bonds face an unprecedented financing hurdle over the next five years as they need to raise about $950 billion dollars, according to Cantor Fitzgerald.

Just how in the world junk bond issuers will raise all of this money in an ongoing environment of bank cash-hoarding and a reluctance to lend is anyone’s guess. I think it’s safe to forecast that many of these companies won’t be able to secure credit or revolving credit because banks aren’t expanding loan portfolios – especially to below investment grade credits like junk bonds.

If you believe, like I do, that junk bonds are heading into the disaster zone amid a tight credit noose still afflicting below investment grade companies then consider shorting or betting against the sector. The upcoming issue of The Sovereign Individual is recommending how investors can play this theme as part of our TSI Chaos Portfolio strategy, which gained 21.8% in 2008.

Junk bonds are the next “bubble.”

I’m off to Vancouver today ahead of the big Agora conference where I’ll be speaking tomorrow.

Texas and the Dakotas Best Municipal Bond Bets amid Funding Crisis

Montreal, Canada.

It’s not a pretty site for state finances.

California, the world’s ninth-largest economy -- is bankrupt once again. The state issued its first batch of IOUs yesterday as its coffers ran dry. Though extreme, California is certainly not alone this year as many other states grapple with a bear market in revenues, rising unemployment and increasingly grow dependent on Washington to fund state and municipal operations.

States face a cumulative shortfall of $230 billion dollars from now until 2011 as revenues plunge since 2007. In 2009 alone, the cumulative budget gap for states is $121 billion dollars, according to the National Conference of State Legislatures. Thus far, 42 U.S. states have slashed enacted budgets to cope with rising demand for services and sharply declining revenues, according to the National Governors Association.

State and local sales-tax revenues fell more sharply in Q4 2008 than at any time over the past fifty years. For the first two months of 2009, 41 states that reported tax revenues saw total receipts fall 12.8% compared to 12 months ago.

Of the $787 billion dollars recently legislated by Congress to boost economic growth, about $246 billion has already been deployed to states. In early June, Treasury issued $25 billion dollars in bond authority available to state and local governments under the Recovery Zone Bonds program.

The bad news, however, is that all of this money is now in the process of being spent by states and by next year more government assistance will be required because state revenues are still declining. This has created a dangerous cycle of government interdependence for the most fiscally challenged states – including California, which by all intents and purposes is basically broke in 2009.

I don’t like buying or owning an investment that relies on government support. We all know the rules can change suddenly in uncertain times and depending on government to secure your retirement or long-term investment goals is the wrong way to invest.

If you own a bunch of municipal bonds then I would carefully review your portfolio to ensure the following:

• Is your state solvent without federal aid? You can obtain this information at your state’s budget survey online or at www.sunshinereview.org;

• If not, consider several top-rated national municipal bond funds as ranked by Morningstar to ensure proper diversification and risk allocation;

• Make sure your municipal bonds or bond funds are liquid. If you have to sell your bonds then ensure there’s no liquidity issue. You shouldn’t have to wait more than 24-hours;

• Limit your portfolio duration to a maximum of 5 years. Duration measures interest rate sensitivity. Though rates will stay low for the foreseeable future, make sure you don’t own long-term bonds with maturities extending beyond 2015;

• States with the best balance sheets include Texas and The Dakotas.

Despite the compelling tax savings, I’m very cautious about most municipal bonds because I’m in the camp this economic expansion will be sluggish for the next few years. Consumers are not spending, the unemployment rate is still rising (at 9.5%) and the housing market has not bottomed. This will NOT be a typical post-WW II expansion because bank credit is not expanding and borrowers are largely absent.

Texas is currently only one of six states not facing a budget deficit. The same goes for North and South Dakota and several others.

In Texas, state revenues are projected to decline 10.5% in 2009 compared to 2008, the state has apportioned some money for emergency funding or a Rainy Day Fund. The Rainy Day Fund was established in 1987 following a severe economic downturn and a sharp decline in oil and gas prices. The fund is expected to reach about $9.1 billion in assets by 2011.

Texas, of course, relies heavily on oil and gas revenues to boost its balance sheet. The state continues to benefit from strong oil prices – which have doubled since February – and will shortly receive $11.4 billion from Washington’s Economic Recovery and Reinvestment Act or the $787 billion dollar stimulus bill. That will further cushion Texas’s coffers.

I like the prospects for Texas longer term. That’s because I’m an oil and gas bull and believe she’ll continue to benefit from the trend in rising energy prices and Peak Oil, or a global phenomenon tied to declining oil production coupled by rising consumption mostly in the emerging markets. You could say Texas is in a “sweet spot.”

Also, Texas, though taking federal assistance – like all states – can live without it. The state is one of the few in the Union to balance its books.

If you must own municipal bonds to reduce your effective tax rate, then be especially careful now. These are not normal economic times. The wrong way to invest for the future is to depend on government to bail-out your state -- which means that in the absence of federal aid your state might possibly default on its debt. Though unlikely, this is a growing possibility in the post-2007 credit crisis.

I’m off next week to Spain for a summer break. I’ll be back blogging on Tuesday, July 14 from Tonsberg, Norway. Until then, Happy July 4th and Happy Canada Day!

Don’t Underestimate the Power of Deflation

In a span of just three months the great safe-haven trade has violently unwound in favor of risk-taking across stocks, speculative bonds, commodities and currencies. And Treasury bonds, which rallied to their lowest yield levels since the 1950s in December, have posted their worst losses since 1994 the first six months of 2009.

Dumping T-bonds has been a great trade this year for several reasons.

First, the yield on the entire Treasury curve was absurdly low heading into January. The bear market in stocks and other risky assets drove investors en masse into safe-haven trades – mostly Treasury bonds starting in August 2007. Then fiscal spending was unleashed as the government attempts to quash deflation in the economy.

The massive supply of Treasury issuance this year has resulted in a deluge of paper hitting the marketplace and investors are increasingly balking at funding America’s multi-trillion dollar deficits at current rates. The Chinese, by far the largest holders of T-bonds at roughly 37% of total outstanding supply, have been unusually vocal expressing their concerns about monster-sized U.S. borrowing since April. Alarmingly, intermediate and long-term rates are violently reversing since May despite aggressive Federal Reserve T-bond purchases as part of its quantitative easing program. Investors should be nervous.

In short, this is the first bear market for Treasury bonds since 1994 and threatens to kill-off the bull market in Treasury securities since it was first unleashed in 1982 – mainly because of too much supply. The era of falling inflation or disinflation has given way to outright deflation since late 2008 – a boon for Treasury bonds. But now the market is concerned about over-supply and the threat of rising inflation as the United States prints its way out of misery.

These concerns are misplaced – at least for now.

The United States currently sports a savings rate of barely 6% of disposable income. That’s not a lot of firepower to spur new borrowing or domestic consumption – especially following a massive bear market in consumer balance sheets, including real estate, stocks and growing job losses. Twelve months ago, the savings rate was barely positive. It’s premature to believe consumers will draw down their newly fortified savings with a parade of fresh spending. That’s unlikely.

The Japanese, who suffered their own version of the “lost decade” in the 1990s, embarked on deflation in 1990 with a 13% savings rate – considerably higher than America’s current rate. Japanese consumers represent 55% of GDP, whereas American consumers represent 70% of total consumption. It’s highly likely that debt reduction and balance-sheet repair will inhibit this recovery and possibly force a repeat of the Japanese malaise more than 18 years ago. Government can print all the money it needs but it can’t force consumers to borrow, spend or purchase a home.

Next, interest rates at the long end are rising rapidly. This has the potential to chock-off any “green shoots” in the economy as refinancing collapses – delaying a recovery in residential real estate.

With stocks seemingly fully priced and certainly not cheap at current levels, Treasury bonds are once again competing with equities. Stock index dividend yields have markedly compressed since March and speculation is now widespread across the same investments that powered the pre-2007 bull market – emerging markets, commodities, foreign currencies. In a new bull market, leadership typically changes; but not since March.

A five-year T-bond currently yields 2.8% and like all T-bonds are heavily oversold while stocks are overbought. Treasury bonds are also selling below par so an investor can lock-in a small capital gain if they hold that security to maturity.

Inflation will make a comeback. No doubt about it. Obama won’t stop until we have inflation again. Yet the transition from a period of historical credit destruction (deflation) – still underway – to rising inflation is still a few years away. Wage inflation is bordering deflation or negative wage growth, housing prices are still deflating and consumer spending remains lethargic. Combined with the lack of bank credit flowing into the real economy, it’s hard to believe the stock market has truly discounted the worst.

This won’t be your typical post-WW II economic recovery.

I’ve started to nibble at five year Treasury bonds. Rates have ratcheted sharply higher since May and, in my view, the next 12 months will see a re-testing of the March 9 lows as deflation returns as a primary threat to recovery. By that time, this round of fiscal stimulus will have run its course and the market will be begging for another New Deal.

Junk Bonds Heavily Overbought Amid Tight Credit Noose

Montreal, Canada

One of the greatest asset reversals has occurred over the last three months with stunning velocity.

Junk bonds, or high-yield bonds, have seen their yields crash since peaking in early March from 17% to just 9.3% now, according to the Merrill Lynch-Bank of America High Yield 100 Index. The index has gained 17% in 2009 – better than U.S. stocks and other segments of risky credit.

According to Moody’s, the U.S. speculative-grade default rate on junk bonds surged to 9.2% in April compared to 8% in March and 2% a year earlier.

Moody’s, however, predicts the default rate will peak at 14.8% in the fourth quarter before declining to 10.4% twelve months from now.

Overall, 89 of the 112 defaults year-to-date were by North American issuers while European companies accounted for another 11 defaults.

With all due respect, these are the same guys that gave high credit ratings to mortgage insurers and a host of banks and investment banks with little or no tangible assets ahead of the credit crash in late 2007. I’m not sure the default rate will peak in the fourth quarter. In fact, I’m betting the opposite will occur.

Historically, the default rate on junk bonds has peaked at around 10-15% in previous post-WW II recessions. But this isn’t a normal recession; we’re still trying to climb out of the worst credit environment since the 1930s with banks mostly hoarding cash and the government still heavily involved in consumer and mortgage-backed lending facilities. This will not be a “normal” post-war recovery because credit expansion remains anemic.

More importantly, if credit to the best rated companies remains challenging then imagine what lies ahead for junk bond rated companies? This group has a tsunami of refinancing coming due from now until 2014 to the tune of $950 billion dollars. If the strongest credits are still struggling to raise capital and certainly paying a premium over short-term lending rates to secure that credit then it only seems logical that junk bond financing will struggle.

In other words, there’s an avalanche of defaults coming our way in the high-yield sector – assuming the economy isn’t in a new bull market. And historically, you never buy junk bonds when the default rate is still rising; still, as default rates have climbed markedly recently junk bond prices have soared. Something is wrong with this picture.

Bear market rallies are always convincing. The worst of the lot get swept away with the short-term trend making an ugly duckling look like a golden goose. This is still a very challenging macro credit environment whereby financing and refinancing trends have not returned to pre-crisis levels.

Yes, the government has done a good job masking the damage and insolvency of the banking system -- including fudging the accounting rules -- but now the real economy is next on the chopping block. This will be a much harder magic trick to follow. We’re nowhere near the end of this bear market in credit.

In the recent issue of my Accelerated Income I just issued a recommendation to short or bet against junk bonds – up 29% since the March low. Moody’s is wrong; the default rate will probably peak north of 20% in this cycle just like it did more than 75 years ago.

Have a good weekend. See you on Monday.