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U.S. Treasuries, the Final Asset Bubble

Interest-Rates / US Bonds Nov 23, 2008 - 04:21 AM GMT

By: Eric_deCarbonnel

Interest-Rates Best Financial Markets Analysis ArticleSo far, the credit crisis has produced four asset bubbles as investors shifted from one asset class to the next. Three of these bubble have burst, but the last one, US treasuries, remains.

The First Bubble—The Credit Markets

The credit bubble that imploded in August 2007 should have been obvious to everyone. When you give mortgages and loans to NINJA borrowers ( N o I ncome , N o J ob or A ssets ), you can't be surprised when you never see that money again. However, most investors ignored the risks and, despite the widespread mortgage fraud and non-existent lending standards (write down your income, we'll trust you), piled into subprime mortgage CDOs and CDOs squared. Naturally, these subprime CDOs didn't perform as expected, leading the credit markets to collapse.

The Second Bubble—Stock

Despite August 's subprime crisis, stocks rallied to new highs in October as investors fled the credit markets. Considering that the frozen credit markets are the lifeblood without which the economy can't function, these new highs made as much sense as subprime CDOs squared. It shouldn't not have surprised anyone that stocks collapsed.

The Third Bubble—Commodities

Running from both the stock and bonds, investors ignored a global economy falling into recession and piled into commodities, driving oil up to an insane level, In the face of the world's plunging demand, the only reason that could possibly have justified $147 oil would have been a complete collapse of the dollar. Since that was not the case, the oil bubble burst and commodity prices plunged.

The Final Bubble—US Treasuries

Now Investors are now panicking into the 'safety' of US treasuries, the last and greatest asset bubble. To be blunt, $147 oil made more sense than .1% yield on the three months note. Anyone who believes treasuries are safe and that commodities will deflate in dollar terms doesn't understand the deep fundamental difference between the 1930s and now.

Back in 1930s, the economy was on much sounder footing than it is today. Stanley K. Schultz, Professor of History at the University of Wisconsin, gives a good description of the US's foreign balance of payments going into the Great Depression:

World War I had turned the United States from a debtor nation into a creditor nation. In the aftermath of the war, both the victorious Allies and the defeated Central Powers owed the United States more money than it owed to foreign nations. The Republican administrations of the 1920s insisted on payments in gold bullion, but the world's gold supply was limited and by the end of the 1920s, the United States, itself, controlled much of the world's gold supply . Besides gold, which was increasingly in short supply, countries could pay their debts in goods and services. However, protectionism and high tariffs kept foreign goods out of the United States. The Hawley - Smoot Act (1930) set the highest schedule of tariffs to date. This protectionism produced a negative effect on United States exports: if foreign countries couldn't pay their debts, they had no money to buy American goods.

From this passage, two clear differences between the 1930s and today should be obvious:

1) The fundamentals backing the Dollar

Back then, the US dollar was a hard currency backed by a mountain of gold. Today, the US dollar is a fiat (paper) currency backed by a mountain of debt.

2) America's Dependence on imports

Back then, the US had absolutely no dependence on foreign goods (discouraged all imports through protectionism and high tariffs). Today, America has a total dependence on foreign goods. We have outsourced a large part of our economy, and we are completely addicted to foreign oil. If the US was cut off from foreign imports due to a currency collapse (like what happened to Iceland ), our economy would completely collapse within a matter of weeks if not days.

When the treasury market collapses…

Interest rates on treasury bills (even 3 months note) will quickly rise into the double digits. The dollars purchasing power will collapse, possibly leading to a foreign-currency lockdown like Iceland's Krona. All stocks (except those that benefit from high commodity prices) will crash. The credit markets will suffer further pain due to rising inflation and default risks. Finally, will Gold will skyrocket.

To protect yourself:

1) Buy physical gold
. When the dollar collapses, there will be panic and confusions outside the US over how to replace the dollar's important role as the world's reserve currency. Since there is nothing else available, my bet is that gold will be used as the world's temporary emergency reserve currency, while nations try to work out a more permanent solution to replace the dollar.

2) Get out of all variable rate loans. If you have the option, refinance your mortgage into a fixed rate. As the rates of 30-year Mortgages are based on 30-year treasuries, the treasury bubble is creating a wonderful window of opportunity to lock in a low fixed rate.

3) Consider leaving the country. America is headed for a transition from being the world's only superpower to being a third world nation with an oversized military (same thing that happened to Russia), This transition is going to be painful, depressing, and probably violent. Once the initial shock is over, there is going to be a lot of anger. I would give serious thought to moving to a creditor nation until the worst has passed.

I would also advise keeping track of developments in Iceland following their financial and currency meltdown. It will offer an optimistic preview of what awaits the US.

By Eric deCarbonnel

Eric is the Editor of Market Skeptics

© 2008 Copyright Eric deCarbonnel - All Rights Reserved
Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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