I don't know how to get around this big obstacle:  the horizon shows nothing but deficits as far as the eye can see.  The present rise in long-term rates, i.e., drop in 30-year Treasury bonds, is partially a repudiation of the Fed's ability to control the long end of the curve in treasuries and mortgage rates. The Fed with all its muscle is not strong enough to do this, so once the emotional shock of their buying program dissipated, the curve steepened, pushed by hedging in the residential mortgage market, once the move became great enough.

The chart in Figure 1 shows the trouble brewing in the bond market.  Note that the 50-day moving average of the 30-Year US Treasury Bond Price Index sank below the 200-day average.  The 30-year T-Bond sank dropped like a rock to a new low today.  This is bad news for housing mortgage rates.  The Fed has been trying, not very successfully, to drive long bond rates down to alleviate the pain in the housing market.  Treasury bond investors are looking at massive auctions of Treasuries in the months directly ahead to finance the out-of-control deficit, and they are wondering who's going to buy all these bonds?  So, in my view, in the next quarters ahead look for increasing mortgage rates as a second wave of loan resets come into play along with a highly-stressed commercial real-estate market.

In Figure 2, we see a three year chart of the same index. In Q4, 2008, the index spiked up, driving rates down as investors were fleeing to a safe haven as the USA financial system came close to meltdown.  In came the Fed, Treasury Secretary Paulson, and lame-duck Bush administration with a plan to try to halt asset deflation and to "save" the financial system by not letting the biggest financial institutions fail and underwriting various efforts to lubricate the frozen credit markets.  The rush to save them was made without regard to how they mishandled their own dealings.

Then came the new Obama administration in Q1 2009 with its plans to socialize banks and even major car markers.  The new presidential team are going to add trillions of dollars to the USA public debt, which is going to go from 40 to 80% of the GDP.  The new administration's spending plan is simply spectacular and mind-numbing -- $13 trillion has been pledged.  This amount is equivalent to a full year's annual output of the United States of America. The government's response is 3 times more (adjusted to today's dollars) than the U.S. spent to fight WWII.  It is 12 times more (relative to GDP) than the total committed to bring us out of Great Depression.  The Fed and Ben Bernanke is staking his reputation that on the theory that these trillions of dollars in new money -- created out of thin air -- can turn around asset deflation.

There are only a few ways in which you can finance that extra public debt. If you rule out default and a capital levy on wealth, you either have the "inflation tax" or you have to painfully cut spending or raise taxes, and either one is not going to be politically popular.

Figure 2 shows what happened to the long term bonds in Q1 2009 as a result of historically massive spending commitments.  Perhaps that is why Fed Chairman Bernanke said "Either cuts in spending or increases in taxes will be necessary to stabilize the fiscal situation…The Federal Reserve will not monetize the debt."  Bernanke's recent comments indicated that the central bank sees risks of a relapse into financial turmoil even as credit markets show signs of stability. He said the Fed won't finance government spending over the long term, while warning that the financial industry remains under stress and the credit crunch continues to limit consumer spending.

China's reaction to all this is that they don't like it. On his recent China trip, Treasury Secretary Geithner has been getting a tongue lashing from Chinese officials regarding their worries about the dollar and their treasury investments.

For the near future, China has limited options.   If they stop accumulating dollars and reserves, their currency would appreciate sharply while their exports are plunging. So in the short run, they are going to keep buying US T-bonds.   However, the Chinese launched a number of new initiatives in the last month that suggest they are pushing for the Yuan to become an international currency and a reserve currency. They are doing bilateral deals with countries like Argentina and half a dozen others in Yuan, not in dollars.

The wild card in the dollar's future is the possible loss of its reserve status.  From a Chinese viewpoint, the challenge is how to get rid of dollars without collapsing the dollar.  China's long-range plan may be to make the Yuan the world's leading (reserve) currency without directly confronting the U.S., i.e., to become the world's leader via economics and without a war.  Their possible plan may be make the Yuan convertible and the world's international trading currency; back the Yuan with a percentage of gold, and make it convertible with gold as the U.S. was before 1933.

China held about $768 billion of Treasuries as of March, according to U.S. government data.  China is the largest foreign holder of U.S. government debt, which so far this year has handed investors the worst loss since at least 1977 on forecasts for ballooning federal budget deficits. The US will be auctioning trillions of dollars of Treasury bonds in the coming months, and we depend on China to buy a goodly portion of those bonds.

The U.S. Dollar Index chart shown in Figure 3, shows the value of the U.S. currency dropping precipitously in the last three months.  The US Dollar Index is a measure of the value of the United States dollar relative to a basket of foreign currencies (Euro, Yen, Pound Sterling, Canadian Dollar, Swedish Krona and Swiss Franc).  If the index drops below 80 in a meaningful way, it could spell serious trouble, in our view.

We're in uncharted waters, so in whatever role you play in investing, be careful, stay flexible, be diversified. Unusual situations beget more unusual situations and we are entering into the land of unintended consequences.

Personally, here is how my current strategy plan lines up in these uncertain times (2-3 years out):

1. Prepare portfolio for inflation down the road as the massive deficit spending and loose money sloshes through the system.
2. Reduce and eliminate debt as much as possible.
3. Hold off on real estate investments as future mortgage rate increases will stall housing recovery.
4. Take a position in "real" technology investments as they are productivity enhancing; technology will help to counter the effects of the recession.
5. Take a position in alternative energy investments with assumption that administration will be funding this area in a big way; it will the help the U.S.A. become less dependent of foreign energy sources.
6. Stay away from long-term bonds and similar instruments as massive deficit funding requirements will drive up long-term rates.
7. Become more self-sufficient in all areas of life, reduce unnecessary expenses
8. Allocate time for learning new skills, gain more knowledge; the more informed, the better.
9. Communicate with your elected representatives to simplify the tax code, halt bailouts, reduce spending, reduce taxes.
10. Fine tune lifestyle for healthier living to minimize health care expenses; become more active and knowledgeable in health care decisions, question costs even if insurance pays.

Steve Szirom