As the fiscal cliff is nearing with the end of the year 2012 in sight and total public debt skyrocketing to the debt limit of $16.4 trillion, investors need to seriously start worrying about the U.S. bond market.
Technically, the bond yields on the 10 year treasury notes are bottoming out. We could see bond yields rising and bond prices collapsing. Just recently, Jim Rogers disclosed that he is short U.S. bonds. Aside from the rising debt and the fiscal cliff, we should note first that 30 year fixed mortgage rates have hit a new high of 3.5% and are on average at 3.4%. As bond yields follow the mortgage rates closely, I expect bond yields to go up too.
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|Chart 1: 10 year U.S. bond yield|
Further evidence of a coming bear market in U.S. bonds can be found on the open interest front. Historically, when commercials are net short the bonds, bond prices will show weakness going forward. This can be seen on Chart 1 versus Chart 2. When the bond yields go down on Chart 1, the net open interest will tend to go to the short side (red curve goes downwards on Chart 2). At the same time, when bond yields go up, the net open interest will go to the long side or upwards. The only time this correlation didn't add up was during the economic crisis of 2008, when bond yields were artificially suppressed.
As we see today, the short interest is at a record high (red curve on Chart 2 makes a dip). If we see the red curve move upwards, while commercials start to get long treasuries, we will see U.S. bond yields go up.
|Chart 2: Commercial net exposure (long = +, short = -)|
Likewise, we can analyze the non-commercial open interest, which is actually the opposite of the commercial open interest. The speculative long exposure to 10 year treasuries is at an all time high of 170000 net contracts. This indicates to me that we are approaching " bond bubble" territory, especially at these low yields.
|Chart 3: Non-Commercial net exposure (long = +, short = -)|
As I pointed out earlier in this article, there is a good chance that we will see decoupling. The stock market is already showing significant weakness, shedding 10% in a few weeks due to an overvaluation/outperformance in the U.S. stock market. The U.S. bond market is overcrowded and is likely to fall. And the U.S. dollar cannot stay strong as QE3 is about to start, in order to put a cap on rising mortgage rates and bond yields.
Since the announcement of QE3 in September 2012, the Federal Reserve didn't execute QE3 as promised in the month October 2012 as can be seen on Chart 4 (the balance sheet's assets remain flat). But considering the weakness in the stock market, bond market and mortgage market, we could soon see the Federal Reserve jump starting the printing presses.
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|Chart 4: Federal Reserve Balance Sheet|
Moreover, do not forget that Operation Twist II is ending soon in December 2012. From then on, the Federal Reserve needs to buy U.S. Treasuries outright on the market, and then we will see their balance sheet expand while the U.S. dollar devalues.
Investors can prepare for a bear market in bonds considering all the evidence I pointed out above. I don't recommend shorting bonds via ETFs. Instead, it's better to go for the gold trade [SPDR Gold Trust (NYSEARCA:GLD)] as the Dow/Gold ratio is quickly declining at this moment. Historically, gold and treasuries go the opposite ways. What's even a better idea is to buy silver [iShares Silver Trust (NYSEARCA:SLV)] to get a higher percentage gain. The silver market is very tight these days and this can be seen in the increasing physical silver buying activity, for example the recently announced follow-on offering at the Sprott Physical Silver Trust (NYSEARCA:PSLV).