The Mysteries of the Treasury Market Revealed!

Oh boy. Just what we need now that the economy is finally getting back up on its feet: More end-of-the-world rumors.

On Thursday Treasury bonds experienced a massive selloff, with the yield on the 10-year bond rising to its highest level since last November. The stock market took a big hit in response. The U.S. dollar fell against every major currency. It was a bad day.

It was because a rumor got started in the professional bond trading community that China is starting to dump its massive horde of Treasury bonds. It's a portfolio worth almost $2 trillion, and it would surely destroy the bond market and the U.S. dollar if the Chinese ever really decided to dump it.

The rumor arose when some unusual trading patterns emerged in a weekly bond auction conducted by the New York Federal Reserve Bank. Each week the New York Fed buys Treasurys, as part of the $300 billion buy program that began about a month ago. It's the Fed's way of keeping long-term interest rates low, to help the economy and the housing market recovery.

Apparently, for the first time since these auctions began, the particular bonds being offered to the Fed were the type that foreign central banks — especially China's — tend to hold. I'm not sure I really believe that foreign central banks hold Treasurys that are any different looking than anyone else's. But that's what the bond experts tell me, and true or not, it was enough to get a rumor started.

As far as I know China hasn't denied it. I'm not sure they ever would. But common sense tells you that they have no possible sane reason to dump Treasury bonds in the first place.

For one thing, when you dump any investment you own, you are shooting yourself in the foot. You are destroying the value of your investment through your own careless and hasty action. If China really wanted to sell, it would have every interest in doing so very gently, very gradually and very quietly.

And surely they know that any big catastrophe in the Treasury market would cause the U.S. dollar's value to fall. And China definitely doesn't want that. The last thing an export-driven economy like China wants is a weak dollar, because it makes it harder for the U.S. to buy their manufactured goods. In fact, most economists believe China is assiduously manipulating its exchange rate in just the opposite direction — to make the dollar as strong as possible.

Oh... and then there's the statistical evidence. Every month the Treasury Department publishes statistics on how much of our government debt is held by various nations. As of the last report, on March 31, China was buying, not selling. In fact, China's portfolio of U.S. Treasury bonds has been growing over the last three months at better than a 20% annual rate. Maybe they changed their minds since March 31, but I really doubt it.

If it's not China or some other central bank dumping, then what caused Treasurys to sell off so hard Thursday?

I don't think it takes a genius to figure that one out. It's a sad fact that the U.S. is running record government deficits, and is issuing record amounts of debt to cover them. Last year, our outstanding debt was 40% of gross domestic product — by the end of this year, it will be 70%. And according to White House estimates, which I believe are wildly optimistic, it will stay at 70% pretty much forever.

There's good news, too, but it also is a reason for Treasury yields to move a lot higher. The good news is that the credit crisis is over, so investors the world around no longer need the safe haven of U.S. Treasury securities. Now that the panic has passed, it's only natural that yields will move up.

But there's also more bad news. Another reason for yields to rise is inflation. Just as we had to run up a lot of debt to end the credit crisis and set the economy on the road to recovery, the Federal Reserve also had to print a lot of money. That's causing inflation to start ramping up. When inflation rises, bond yields have to rise too, to compensate investors for the loss of future purchasing power.

Now here's where it gets tricky. The Federal Reserve can see what's happening to Treasury yields, and it doesn't like it one bit. With short-term interest rates already at zero, all the Fed can to now to help the economy start growing again is the keep long term rates low. That's why the Fed is buying $300 billion of Treasury bonds in those auctions. As yields move higher despite the Fed's buying, the Fed is going to have no choice but to buy even more.

But that leads to trouble. Because when the Fed buys more, it has to print money to do it. That means even more inflation. And that means yields will need to move higher still, caused by the Fed's very attempt to keep them from rising. It's a classic vicious cycle.

Famed investor George Soros calls that particular kind of vicious cycle “reflexivity.” It happens when events in the financial markets (bonds) influence the real world (inflation), and that in turn affects the financial markets all over again, which then affect the real word all over again (and so on and so on).

Soros put that principle to work in 1992, when he observed that the Bank of England was keeping the value of the U.K.'s currency artificially high. Soros and other investors sold short British pounds in massive quantity, forcing the BOE to raise interest rates sharply in order to defend the currency. The high interest rates weakened the British economy, which caused the pound to fall, which forced the BOE to raise rates more — and so on. Ultimately the BOE gave up and the pound collapsed, and Soros reportedly walked away will billions of dollars in profits.

I think the same thing is going to happen sometime in the next year with the Fed. The market will drive Treasury bond yields higher and higher — the reality of a recovering economy and massive deficits demands it. The Fed will intervene, which will hold down yields for a while — but soon the inflationary consequences of that intervention will drive yields higher still. The Fed will eventually give up, and when it does, the yield on the 10-year bond will probably be 5%, 6% or even higher — today it is 3.35%.

That will surely trigger a massive drop in stocks, and probably a recession. I hope the Fed can delay that inevitable day long enough so that the economy can experience some real growth before it happens