(06/06/12) How to Play Treasuries' Next Leg Down

This has been a one step forward, two steps back kind of recovery, and there are no clear signs that we're even gaining traction...so how do you profit in investors flight to safety? Keith FitzGerald of Money Morning shares his answer..

In the wake of last Friday's disastrous jobs number, ten-year Treasury Note yields finally fell through the 1.5% level, trading as low 1.44% on the day.

That plunge took many traders, talking heads, and politicians by surprise. Our "leaders" in Washington DC were heard to say: "Nobody saw this coming."

Well, that's just not true. Not one iota.

If you've been reading Money Morning, you saw this coming. I've been warning that ten-year yields would drop below 2% and then hit 1.5% for more than two years now. And now that we've busted 1.5%, the next stop is 1%. I can even see negative yields ahead, meaning that investors who buy Treasuries will actually be paying the government to keep their money.

Be prepared. I'm going to show you here what to do, and-yes, how you can profit from this move, even at this stage of the global financial crisis.

Why Bond Yields Will Continue to Fall
First off, ten-year yields dropping to 1% means several things:

Bond prices go even higher. Rates and prices go in opposite directions. Therefore when you hear that yields are falling, this means that bonds are in rally mode.

The world is more concerned with the return of its money than the return on its money. You can take your pick why. Personally I think it comes down to two things above all else: the looming disintegration of the Eurozone and the fact that our country is $212 trillion in the hole and warming up for another infantile debt-ceiling debate instead of reining in spending.

More stimulus. Probably in the form of a perverse worldwide effort coordinated by central bankers as part of the greatest Ponzi scheme in recorded history.

But 0% or negative yields-right here in the US of A?

Yes. Given the state of financial disarray in our world today, this is no longer just a probability. It's moved into the "likely" category. Remember your history:

During the Great Depression, US bonds traded at negative yields when investors didn't trust the banking system or corporate bond markets.

During the 1990s, Japanese Federal bonds went negative as investors sought safety above all else. I remember mouths agape all over the trading floors when it happened and people realized that the unthinkable had just become reality. The headlines here give me a terrible sense of deja vu.

In January of this year, Germany sold ?3.9 billion worth of Federal German T-bills at -0.0122% yield, reinforcing the relative safety of German finances versus Greek and EU finances in general.

Last week, German, Danish and Swiss bills all traded at negative yields.

How low can bond yields actually go? I don't know for sure, but the bond markets on both sides of the Atlantic give us a pretty good idea at the moment.

Take German ten-year bonds, for example. They closed Friday at a yield of 1.17%. When you subtract the 2% that's the official inflation figure, it suggests investors may be willing to accept negative real yields as low as -0.83%.

Here in the US, ten-year bonds recently closed at a 1.45% yield. Subtract our latest official inflation rate of 2.3%, and that suggests investors may push yields all the way to -0.85%.

Shorter-term investors may accept far less-perhaps yields in the negative 1% to 3% range, which again implies that anybody who buys these things is willing to end up with less money at maturity than they started with when they bought the bond or T-bill.

Enough bad news. Let's move on to the good stuff and how we make money from this nonsense.

How to Play the Bond Market From Here
If you already own bonds, hang on to them for a little while longer. But for goodness' sake, begin planning your exit now.

The last thing you want is to get caught by surprise when the central bankers go into stimulus mode and bond yields jump on the (mistaken) assumption that everything will be hunky-dory again. I suggest some very tight trailing stops are in order for everything from individual bonds to bond funds and ETFs.

If you're debating whether to buy bonds or not at the moment, keep your duration under three years, and confine any purchases to speculative capital.

Bonds are traditionally thought of as safe-haven investments, but at this stage of the game, they're more like jet fuel in search of a match. There is such a flight to safety that what used to be the safest assets on the planet have now ironically become among the riskiest.

Bear in mind that if you decide to buy bonds at this point you are going up against the savviest professional traders on the planet, all of whom are out for blood right now. Don't let them have yours.

I realize that neither of these alternatives may be your cup of tea, so let me offer something else for consideration: Rydex Inverse Gov Long Bond Strategy Inv (RYJUX) or the ProShares Ultrashort 7-10 Year Treasury ETF (PST). These are both specialized inverse funds that will appreciate sharply when bonds ultimately do reverse.

Keep in mind, though, that these funds may be more appropriate for traders with short attention spans than longer-term investors. Even so, under the circumstances, they may perfectly suitable for investors willing to average in and put up with the distortion introduced by tracking errors over time.

In closing, there's a lot of talk about how rates can't possibly go any lower. Don't buy it-Japanese ten-year bonds are at 0.82%, while German ten-year bonds are at 1.21%.

Not only can rates go lower, but absent a comprehensive, practical solution to the world's debt problems-like actually reining it in-we will get there. Just remember, you heard it here first that ten-year note yields will hit 1%.

And don't forget to immediately refinance your house if you own one-30-year rates may touch 2.5%, which is also unthinkable right now.