Oh Bernanke - How Wise You Are

It seems to have started. The market is wrestling its way out of the control of the government. The idea of controlling and manipulating the world to do exactly what you want it to do just does not always work, does it? Frankenstein's creator realized that, Bernanke eyes may be opening also.....nah, he is just going to try harder because it has to work, it just has to.

Of course what I am referring to is the MASSIVE 30yr bond and 10 yr treasury sell off. The spread between 2 year and the 10 years (the difference in yield) is now the widest ever. Historically this can mean recovery if it is occurring for the right reasons. Why it is occurring now is not the right reasons. Investors are avoiding long dated government debt out of fear and staying close to the front end of the yield curve (close to today in looking at maturity). This of course causes borrowing costs to go up, especially for things like houses. Uh Oh, Bernanke does not want this and has been doing everything in his power to manipulate rates lower so this does not happen. In the biggest paradox or irony of ironies, one of the main reasons the rate is skyrocketing higher is because Bernanke has been trying to manipulate it lower. DUH. Why does Bernanke not understand the obvious??

So the government is pumping tons of money into the system and doing it through a mix of borrowing and printing. This massive borrowing does two things. Increases the massive supply of debt so you must find demand somewhere. One way demand comes along is that yields go higher. The second thing it does is make the balance sheet weaker. This of course increases the "risk" of government debt (i.e. losing the AAA rating). Basically the risk of default goes up as the balance sheet becomes sicker. Investors demand more yield for this. In this case this part is probably small. It is not zero like many assume but I don't think it is a huge part of the yield demanded...yet.

The second aspect is printing. The Fed announced a couple of months ago they were going to start buying bonds. The purpose, to print money and push/manipulate yields lower. There is one problem with that. By printing money you are increasing future inflation. Well that causes yields to go up.

So you have 3 things converging that government debt holders all of sudden decided to notice (I think to early). Increasing supply, increasing risk, and future increasing inflation. All manufactured in some ways by the Fed's grand scheme to create the opposite (they do want inflation, just not massive inflation).

This in itself I think is still just warning shots. Shots across the bow per say. This is the scenario that I think unfolds into a death spiral 12, 24, 36, 60 months out and your seeing what it will like on a small scale. I think there is still a 50/50 shot that the 10 yr will break its 10 year yield low which was somewhere around 2.2%. I would get very strong arguments against that and I may be assigning to high a probability to that but there is no way I would be short government debt at this point other than maybe for a trade. The reason is the problems are still to big. If the yields keep going up, that in itself will cause the yields to crumble because it will choke off recovery and inflation. I still think the huge second wave of defaults coming in option arms, alt a, prime loans, commericial real estate, and corporate defaults will squelch any near term inflation concerns even with the governments massive intervention.

Here is the problem and why you should be taking notice of what is happening right now. If I am right, Bernanke will just increase the government printing and the government debt. The second wave will come with a roar and Bernanke will try the same things that haven't worked and still won't work. At some point you cross the tipping point. When that occurs government bond holders will wake up one day and say holy **** and the yields on the government debt will start a long steady climb to the moon along with inflation. That is the tipping point that terrifies me because that is when we are done and it will be to late for the government to reverse course.

A couple of things. This isn't inevitable just likely if we keep going down the current course. Also, I think it is still a long distance out. It goes with my theme that deflation will lead to massive inflation. The deflation is going to take Bernanke and walk him straight to overshooting and creating US of Zimbabwe.

What this means for stocks in the short term, I really don't know. If I had to guess, if we go down to 883 again, we will break it this time. We will not hold that level one more time.

If I also had to guess, there will be some solution in the short term to rates not going up. Maybe the 10yr breaks 4% but through a coalition of central bank intervention or some short term patch Bernanke comes up with, the 10yr will stop its climb and will eventually head lower (like I said I think there is a 50/50 chance the 10 yr in the next 12 months goes back down to 2.2%, I am not putting any money behind that thought at all, I just wouldn't be shocked).

Like I said, I think for all investors, this is the playbook with how the end could be written on a much bigger scale. Ignore at your own risk. At some point, what I have talked about for months and what I have termed, currency inflation depression will happen. The economy will continue to deteriorate but currency inflation will kick in regardless.