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Why Are They Laughing at Timmy…And How Will it Affect Your Wealth?

|Includes: TBT, iShares 20+ Year Treasury Bond ETF (TLT)

Chinese business and social culture are generally very subdued and conservative… and above all, respectful. But students at Peking University in Beijing just couldn’t help themselves this week.U.S. Treasury Secretary, Timothy Geithner traveled to China, hat in hand, to allay the concerns of our biggest creditor about the soaring budget deficit and Washington’s loose monetary policy. And by loose, I mean that we are rapidly printing the dollar into worthlessness.

In a speech before the student body, Lil’ Timmy told those gathered that Chinese dollar holdings and investments in U.S. debt were safe and that the U.S. Treasury and Federal Reserve are committed to a strong dollar policy.

Ha! That’s a good one. And the Chinese students let him know it, with a collective belly laugh. I suspect some of them were actually rolling on the floor. And they weren’t laughing with him. They knew he was full of it. I expect you do too.

Despite ongoing assurances to the contrary, the U.S. government doesn’t want a strong dollar policy. In fact, they WANT to inflate the dollar to nothingness. They just don’t want it to happen overnight.

The official U.S. debt is around $13 trillion. But that is only part of the story. Do you remember Enron and WorldCom and the fraud of “off-balance sheet accounting”? This is a dishonest accounting trick whereby companies set up satellite corporations to hide their true liabilities from auditors and investors.

The king of off-balance sheet accounting would have to be the U.S. government. You see, the “official debt” doesn’t include the very real obligations our country owes for Social Security and Medicare. Add these and a few other entitlement programs to the equation and the United States’ TOTAL debt is in the neighborhood of $100 trillion.

This is an astronomical sum of money that can NEVER be paid in real terms – even if most government services were virtually eliminated and taxes were doubled across the board. The only solution is to inflate the debt away by devaluing the dollar. The scoundrels in Washington are rarely honest about anything. You didn’t expect them to actually run a tight ship and pay our debts legitimately, did you?

The only problem is that the present financial crisis, bailouts and money printing operations have rapidly accelerated the process. The bond market knows it. And China knows it.

So how do the Chinese plan to protect themselves? And more importantly, how can you protect your wealth and profit?

First of all, it is important to understand that what countries say they are doing with their currency and foreign reserve holdings and what they are actually doing are rarely the same. Poker players don’t show their hands and use intentional misdirection. In this poker game however, the stakes are in the billions and trillions. So you have to learn to read through the headlines.

China says that they are still committed to their investments in U.S. Treasuries… that they will continue holding dollars… and that gold is not really an option. What else would you expect them to say?

In reality, China has been adding to their gold reserves as fast as they can without driving the price up too quickly. And they have been doing so undercover, through intermediaries. They are also soaking up nearly every ounce of gold that is produced within China. While China is now the number one gold producing country in the world, their production does not hit the world markets.

Diversifying out of their dollar holdings is a tricky process as well. China obviously can’t just dump their dollar holdings overnight. What they are doing instead, is slowly converting their debt instruments and paper wealth into real things… copper, steel, lumber, concrete, cotton, wheat, soybeans and precious metals.

And instead of buying long dated U.S. Treasuries that mature in 20 or 30 years, they are buying instruments with shorter term maturities.

And finally, of course, the Chinese (and other countries as well) are plowing any excess exchange reserves back into their own country to provide economic stimulus. In November, the Chinese government announced a nearly $600 billion internal stimulus package.

This is bad news for the U.S. government bond market. Just as America’s spending goes parabolic and we need to sell more debt than ever, the biggest buyer is walking away from the trading floor.

The Federal Reserve might control short term interest rates, but it is the market that controls long-term rates. And just like any market, this one responds to supply and demand. With a budget deficit of nearly $1.8 trillion this year and soaring deficits as far as the eye can see into the future, there is going to be a glut of supply. And we have already addressed what is happening to the demand.

The Fed’s solution is to step in and buy our own debt, when other countries and institutions are unwilling or unable to do so. But this creates a catch-22. This amounts to nothing more than printing dollars. And the more dollars we print to buy our own debt, the weaker the dollar becomes and the less likely that foreign countries are willing to buy.

In my view, there is only one way this scenario will play out. Get ready for soaring interest rates, hyperinflation and exploding gold and silver prices. It is not going to happen overnight, but I don’t see any way it can be avoided.

It used to be difficult for small investors to use the market to profit from rising interest rates. Today, it is as simple as buying or shorting an ETF. The chart below shows the yield on the U.S. 30-year Treasury bond. In the early 1980s the yield peaked around 16%. It has been falling ever since. As yields fall, bond prices rise, so what you are looking at below is a 28 year bull market in U.S. Treasury bonds.

But pay attention to the last six months…

 

That spike represents what I believe will mark the end of the bull market in the “long bond”. And it represents the beginning of a new era of rising interest rates.

Certainly, you should own gold and silver and precious metals equities. But you should also consider pairing that investment with a bet against long-term U.S. government bonds. The way to play it is to short the iShares Barclays 20+ Year Treasury Bond Fund (TLT) or buy the ProShares UltraShort 20+ Year Treasury Bond Fund (TBT).

The TBT is an exchange traded fund that returns two times the inverse of the daily performance of the long bond index. Do not buy your entire position all at once. Leg into this position incrementally over the next six months or a year.

To Your Success,

Jon Herring