The Coming Bond Market Collapse: 3 Ways To Escape The Damage

Includes: GLD, SLV, TBT, TMV, TTT, UBT
by: Wall Street Wisdom

Just when you've finally gotten over the stock market crash from four years ago, there's a new threat that could potentially hit your portfolio. Even worse, it's in an area that many people think of as being safer than stocks: the bond market.

We're on a collision course with the worst bond market collapse in decades and the warning signs are as clear as day. There's still time to dodge the damage - and even to profit - if you know what to look for.

But the time to make your move is now…

Three Facilitators for a "Total Bond Market Collapse"

U.S. Treasury bond yields have been falling steadily since the beginning of 2011, with the 10-year Treasury yield falling from 3.54% to its current yield of 1.78%.

Source: Ycharts

Investors have piled into bond investments over the past several years, accepting lousy guaranteed returns in exchange for the near-certainty that they won't lose any principal. Various levered (NYSEARCA:UBT) and inverse levered long Treasury bond funds (TBT,TMV, TTT), will continue to generate activity and interest. With Treasury bond volatility now roughly equivalent to the trailing volatility of the S&P 500 (NYSEARCA:SPY), this market will continue to be a place for traders to tactically position with the hopes of short-term gains, but for how long?

While this example only represents a moderate decline in bond prices, take heed: That gentle slope leads directly to the precipice of a bottomless pit - a total bond market collapse.

There are three key factors that will cause - and even hasten - the coming bond market collapse. These catalysts are easy to spot - indeed, they're in the headlines virtually every day.

I'm talking, of course, about monetary policy, inflation and the federal deficit. Let's take a detailed look at each of these potential bond-market-collapse catalysts:

The Monetary Policy Blues

U.S. Federal Reserve Chairman Ben S. Bernanke has kept interest rates virtually at zero (0.00%) for 54 months, with inflation jumping .4% in March. At the latest FOMC meeting, Bernanke has announced the Fed's plan to continue buying $85 billion per month of U.S. Treasury debt and mortgage-backed securities. He's not going to raise interest rates anytime soon, which means inflation could potentially accelerate, mostly through commodity prices. And when he stops buying Treasuries, where will that leave the investors?

The Inflation Conflagration

Inflation had been running very low ever since the recession, but in the last six months, the producer price index (PPI) has risen at an annual rate of 12%. That will feed into the consumer price index (CPI) over the next few months, which already experienced the largest over-the-year increase in February - the largest increase since the 2.9-percent advance in March 2012.

At some point, bond buyers will realize inflation is back and panic. After all, even though inflation never got above 14% in the 1970s and 1980s, long-term bond yields got to 15%. For bond yields to move that high from here, bond prices would have to fall an awfully long way.

The Federal-Deficit Follies:

The real cost of the $787 billion "stimulus" of 2009 is the $1.12 trillion deficit we are now struggling with. The United States has never run a deficit of anywhere near this magnitude, and it's becoming obvious that near- trillion-dollar-plus deficits are here until 2015. That's another reason for the bond markets to panic - and is another reason to fear a bond market collapse.

Worse Than the 70s

Combine those three factors, and you're looking at the potential for a truly epic bond market collapse, worse than anything that we saw in the 1970s. If you ask me to bet, I would say the bond market disaster will start in the third quarter - even CPI inflation figures are likely to be looking pretty creepy by then. Before then, you will probably see a continuing creep upwards in bond yields, perhaps reaching 4% on 10-year Treasuries by early June.

How to protect yourself? Well, obviously gold and silver are part of the solution, at least until the Fed starts fighting inflation properly, which I don't expect to happen before next year.

In fact, I would recommend you have at least 15% to 20% of your portfolio in gold and silver, the traditional inflation hedges.

Of course, the short story is that both metals have exchange-traded funds that track their price fluctuations - namely the SPDR Gold Trust (NYSEARCA:GLD) and the iShares Silver Trust (NYSEARCA:SLV).

The other solution is to bet on the bond market collapse itself. To do that, I'd recommend a look at the ProShares UltraShort Barclays 20+ Year Treasury Exchange Traded Fund (NYSEARCA:TBT), which aims to rise by twice the amount that long-term Treasuries decline. Like all leveraged inverse funds, this accumulates tracking error if you hold it too long. However, I don't think we'll have to hold it for more than a few months this time, so the tracking error should be modest.

People have been predicting a sharp rise in bond yields for a few years now, and they have been wrong. However, I think those predictions of a bond market collapse are likely to come true within the next few months, and when they do, they'll come true with a bang.

Investors are looking at a bond market collapse, and it could start in the third quarter. But don't wait until then to adopt defensive investments. Start positioning yourself now.

The U.S. Federal Reserve's loose monetary policy and the inability of our elected representatives in Congress to rein in the U.S. debt load have undermined both the U.S. dollar and the nation's economic recovery.

There is no safe place to hide, but owning gold and other precious metals such as silver could go a long way toward preserving your wealth - at least until the Fed starts fighting inflation properly, which I don't expect to happen before next year.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.