Bloodbath in the Treasury Market

Obama's inflationary fiscal policy is negatively impacting treasuries.

Investors have been blindsided by one financial catastrophe after another over the last 18 months, but throughout the tumult, the government bond market has been their friend.

Until now.

A brutal drop in long-dated Treasury prices has caught even the best money managers off guard—in some cases wiping out as much as 60 percent of the gains they booked in last year's huge rally in U.S. Treasuries.

The Vanguard Group, Fidelity Investments, T. Rowe Price and Hoisington Investment Management have seen their government funds down anywhere between 10 percent and 30 percent, as record amounts of debt flood the market to pay for the swelling budget deficit.

What's stunning about the portfolio declines is the swift plunge in Treasury prices within a short period of time despite the Federal Reserve's buyback purchases intended to hold down interest rates. Benchmark 10-year Treasury yields have surged to levels not seen in more than six months, resulting in meaningful losses for many portfolios.

The 10-year T-note and 30-year Treasury bond are down 8.58 percent and 24 percent, respectively, in terms of price for the year to date.

Here's how this works:

The growing inflation rate is causing the professional investor to raise their required risk-adjusted rate of return on investments to keep their purchasing power up. Since the market is stabilizing and less risky than several months ago, the rate of return from equities looks more attractive now. Therefore, capital is shifting away from treasuries (thus the price drops) and into equities (thus the rise in the stock market of late).

The problem this causes for the Treasury though, is they have Obama's jaw-dropping deficits to finance. Therefore, look for interest rates to keep climbing as the Treasury competes with the equity market for capital. You should see money flowing back and forth between the two markets for quite as while.

So who gets hurt by this?

Well, the taxpayer for one, because we will have to chin the higher costs of interest on the debt. But private business will get a double whammy, from both the inevitable higher taxes on profits and the higher interest rate to access capital that will result from the inflation.

As I have mentioned before, in the late 70's we used to talk about "crowding out" (government soaking up the credit and crowding private business from the credit market) and stagflation (high unemployment and high inflation).

I think we will soon start hearing those terms again.