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With the debt ceiling approaching rapidly in just a few weeks from now, I wanted to give an update on the status of the U.S. treasury market. I warned about a bond bubble here, stating that short interest in the commercials was going up dramatically. The last months we have seen weakness in the bond market as a result, but if you think it's already over, I have to disappoint you.

The bond bubble collapse hasn't even started yet. On Chart 1 we can see that since that article, the net short positions for the commercials has even gone up (pointing to a weak bond market and a bottoming out of yields), and the non-commercials have kept buying more and more bonds, thinking it would be a good investment. If these non-commercials unwind their long positions, we will start to see the real bond bubble collapse.

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Chart 1: Commercial Open Interest in Treasury Notes

Even though non-commercials are buying like crazy, the yields haven't gone down. On Chart 2 we see that yields have risen even when long positions in non-commercials went up. This is not a normal event.

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Chart 2: 10 year U.S. bond yields

The reason U.S. bond yields have been going up is to be found in the declining value of the U.S. dollar. In just two months the euro/USD exchange rate went from 1.2 to 1.35. That's a decline of 12% against the euro. This is partly due to improving conditions in the European bond market and partly due to the start of the unsterilized U.S. bond buying and mortgage backed security buying. You can clearly see that the Federal Reserve has started QE3 since November 2012 on the next chart (Chart 3). This expansion of the money supply will devalue the U.S. dollar by 30% over the course of 1 year against a real currency like gold (NYSEARCA:GLD). This can be easily calculated when you look at the percentage growth in the Federal Reserve's balance sheet, which is $1 trillion/year on an asset base of $3 trillion. Gold will be at $2500/ounce in a year from now if QE3 devalues the U.S. dollar by 30% in one year's time.

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Chart 3: Federal Reserve Balance Sheet

Though, the real fear today is the debt ceiling, which will be breached mid February 2013. If Congress fails to raise the debt ceiling, it first means that interest expense on debt should be paid with tax revenue. At this time revenue far exceeds interest expense, so that won't have a major impact just yet (at these low bond yields). But second, it also means that maturing debt won't get repaid on time unless it's going to be rolled over. We are talking about $500 billion in maturing debt in the months of February-March 2013. Of course, the U.S. isn't going to pay off this huge debt and is going to roll it over partly through QE3 ($45 billion/month bond buying program). The other $455 billion will come from foreign investors who are willing to buy this debt in the short term. The problem is that foreign investors will ask higher interest rates on this debt and we already see this happening through the rising bond yields.

To put it simply, the U.S. pays off its maturing debt by going into new debt with foreign investors (at higher interest rates). By definition we call this a "Ponzi Scheme." Debt gets paid until someone stops buying new issuance of debt. But what if the debt ceiling isn't raised and what if foreign investors aren't willing to buy new debt anymore? Then this $455 billion in maturing debt will not get paid. Luckily, foreign investors are still willing to buy U.S. debt. In November 2012, net foreign bond buying went up to $30 billion. Total foreign holdings today are $5.557 trillion on a publicly held debt of $11.58 trillion. That is an astonishing 48% of debt held by foreigners, which is the highest percentage in decades as I pointed out here.

We need to ask the question: "Will this debt ever get repaid?" At this moment, the answer is certainly "no." Otherwise, the percentage of debt held by foreigners wouldn't increase at this pace. There is a limit though, that limit is found in the ratio of interest payments compared with tax revenue. Currently we are talking about a ratio of 18% for the U.S. But this ratio can spike upward when public debt grows or confidence is lost in the U.S. bond market. That loss in confidence will be evident when the U.S. enters a currency crisis in the next few years. I would get rid of those U.S. Treasuries (NYSEARCA:TLT) if you happen to still possess them.

Source: The State Of The U.S. Bond Market Is Getting Worse