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Make no mistake, Bill Gross isn't optimistic about the prospects for the U.S. dollar or U.S. Treasury bonds. In PIMCO's investor newsletter, Gross adds to the growing chorus of dire predictions regarding the fate of the world's reserve currency and debt issued by the U.S. government. Citing annual reports from the International Monetary Fund (IMF), the Congressional Budget Office (CBO), and the Bank of International Settlements (BIS), Gross notes that the U.S. is one of the worst debt 'offenders' in the world.

Rather than reference the fiscal deficit, the IMF, CBO, and BIS evaluate the U.S. based on a measure called the 'fiscal gap'. Unlike the 'deficit', the fiscal gap includes entitlements such as Social Security, Medicaid, and Medicare. To address this issue, Gross notes that these entitlements are in essence no different than bond payments and thus should be included in debt calculations:

We owe... not only $16 trillion in outstanding, Treasury bonds and bills, but $60 trillion more. In my example, it just so happens that the $60 trillion comes not in the form of promises to pay bonds or bills at maturity, but the present value of future Social Security benefits, Medicaid expenses and expected costs for Medicare.

In all then, these entitlements plus bond coupon payments and redemptions total around $76 trillion in debt or around 500% of GDP putting the U.S. on par with Greece -- fortunately for the U.S., the dollar is the world's reserve currency.

Gross complies the figures from the IMF, CBO, and BIS and concludes that in order to keep its debt-to-GDP ratio from spiraling out of control, the U.S. would need to cut spending or raise taxes to the tune of $1.6 trillion per year:

An 11% "fiscal gap" in terms of today's economy speaks to a combination of spending cuts and taxes of $1.6 trillion per year!

The closest the U.S. has been able to come so far: the 'super committee's' failed attempt to secure $400 billion per year in cuts.

Gross also plots 13 countries on a graph showing where each stands regarding the fiscal gap (x axis) and 2011 public debt-to-GDP (y-axis). The U.S. falls into a group comprised of Japan, Spain, and Greece. Needless to say, that is some bad company.

Gross concludes that if the U.S. doesn't act, it will

...begin to resemble Greece before the turn of the next decade.

As for how to position for such an event in terms of asset allocation, Mr. Gross doesn't mince words:

Unless we begin to close this gap...our debt/GDP ratio will continue to rise, the Fed would print money to pay for the deficiency, inflation would follow, the dollar would inevitably decline, bonds would be burned to a crisp, [and] only gold and real assets would thrive.[Emphasis mine]

Of course the idea of Congress being able to agree on $1.6 trillion in spending cuts and/or tax hikes per year is laughable. Should the U.S. be unable to bring the situation under control, Gross predicts that ratings agencies, bond holders, and nations which hold dollar reserves could cease to view the U.S. as the safest of safe havens.

Should this happen, yields could begin to rise on Treasury bonds against the Fed's wishes. From there, the unraveling begins, as the Fed's DV01 could well be $4 billion at that juncture considering the expected rate of asset purchases. While the pay-off may be some ways off, shorting U.S. Treasury bonds (NYSEARCA:TLT) could produce quite the pay day in the years ahead. In the mean time, gold (NYSEARCA:GLD) should continue to outperform.

Source: Bill Gross Says Treasury Bonds Will 'Burn To Crisp', Gold To Thrive