Montreal, Canada

Over the past 12 months, I’ve bought and sold a reverse index on long-term Treasury bonds twice anticipating a major pullback in prices or a significant rise in yields. On both occasions, I sold this position at a loss because lingering economic weakness and renewed credit fears continue to spur purchases of Treasury securities, driving bond yields sharply lower.

Only six weeks ago, benchmark ten-year Treasury bonds saw yields ratchet to 4% before rallying to this morning’s 3.23%. That’s one heck of a rally.

The premise behind betting against Treasury bonds is simple enough. It’s also logical. The United States issued a record amount of T-bonds in 2009 to finance bloated bailouts and huge deficits; over $2 trillion dollars’ worth of these securities was issued last year with the Federal Reserve purchasing about 17% of total issuance amid quantitative easing, according to Montreal-based Bank Credit Analyst.

Yet in 2010, Treasury is expected to issue about the same amount of government paper or about $1.9 trillion dollars. An investor would expect such a swamp of supply to eventually overwhelm the markets, thereby forcing bond yields higher; but that’s not happening.

Despite a few poor auctions earlier in the first quarter, Treasury has successfully sold a few hundred billion dollars’ worth of T-bonds this year with barely a hiccup. Even more amazing is the fact that longer dated paper (e.g. 30-year T-bonds) are drawing the bulk of Treasury buying lately as the credit crisis spreads and deepens across Europe. Yesterday, Treasury sold two-year notes yielding just 0.77% -- the lowest ever. And long-term bonds are generating the biggest bids this month as yields crash from 4.52% on April 30th to 3.96% last night.

I constantly ask myself “who in their right mind would buy 30-year U.S. Treasury paper amid a deluge of supply coming as far as the eye can see?” Is it pension funds and life insurance companies? Why are they lunging after 4% paper burdened by structural deficits with no plan in Washington to cut spending? To me, it seems like financial suicide.

Worse, any sensible investor, especially shrewd bond market investors, can do the math. The United States is heavily indebted, will never pay back its entire lot of obligations and at some point, a sovereign bond market crisis is probably going to smash right into the Treasury market. Richard Russell, my favorite market seer, believes the Feds will grow their way out of this mess by printing mountains of money and thereby devaluing the dollar. I totally agree.

But for now the world seemingly loves Treasury bonds. The stuff pays barely a decent yield and after inflation (2.2% annualized) and the prospect of high inflation down the road investors are really getting a raw deal. Unless, of course, deflation is threatening to ruin the financial system once again.