Have the Bond Vigilantes Finally Woken Up?

Bonds sold off hard today after the results of the 5 year auction were announced. As you can see below, it wasn't pretty:

The bid to cover ratio of 2.55 can only be described as ugly. The primary dealers got stuck eating just about half of the auction which is another sign of weak demand.

My Take:

So now we need to ask ourselves: Has Bondzilla awoken as a result of the passage of healthcare reform? The last time we saw the bond vigilantes was back in the early '90's after Bill Clinton was voted in as President.

Ironically, the trigger for the sell-off in bonds back then focused around the exact same issue except it was called "Hillary Care" last go around.

Here is the cliff note version of what occurred:

Clinton announced colossal spending programs when he got into office. The largest piece of the spending revolved around nationalized health care. The bond vigilantes responded immediately and sent yields threw the roof until Clinton backed off on his spending.

Clinton eventually backed down, and a few years later the economy soared when the tech boom hit. Our deficit rapidly turned into a surplus over this span because the bond market forced the government to keep their spending in check.

What scares me about today's problems is the economy is much more fragile and vulnerable this go around versus the early 1990's. If the bond vigilantes decide to run up yields in response to our deficits and spending on massive programs like health care reform, the economy is going take a dramatic turn for the worse.

The problem this go around is our deficits are trillions not billions. There is no way that this can be turned around anytime soon. If rates shoot up, the banks are going to be in a world of hurt because their balance sheets will deteriorate significantly. Home values will drop as a result of higher borrowing costs. This will put further strain on the consumer.

Sophie's Choice

It must be hard to be a "bond vigilante" right now. Basically they can't win. All of them know that our spending is ridiculous and completely out of control. The problem they have is if they take rates higher, they risk blowing themselves up in the process because it could very well take down the whole economy.

If they continue to ignore the problem and let our deficits continue to overwhelm our GDP than we risk becoming the next Greece or Iceland.

I am glad I am not in their shoes! Let's hope that they have the strength to do their job and force the government to stop all of this insanity.

Let's face it, the only fiscal "cops" left in this economy are the bond vigilantes. If they don't wake up and force the government to rein in its spending, this country is in serious trouble.

It has become clearly obvious that Wall St, Washington, and the Fed have a spending "addiction." The disease has totally taken them over, and they can now no longer control themselves.

It's up to the bond vigalantes to clean up this mess because none of our politicians have shown the desire to stand up and prevent this economic trainwreck and its catastrophic consequences.

The Bottom Line

The market is really starting to get interesting. You have the dollar soaring as Europe falls apart. Adding to the fireworks is the fact that the Fed plans on exiting the MBS and Treasury markets at the end of the month.

This event should be really interesting to watch if rates continue to rise. Talk about a recipe for disaster!

Equities meanwhile have continued to rise in the process which has surprised a lot of the pros. Many traders expected equities to move to the downside when the dollar started to soar. To date this hasn't been the case.

IMO, the one thing that has defined the stock market during this meltdown is the contrarion way in which it moves. It consistently yins when it should yang. Assets that should collapse rise and sometimes even soar.

The examples of this are endless:

• Commercial real estate
• Banks
• Fannie (FNM), Freddie (FRE), AIG
• Junk Bonds
• Treasuries (until today)

I could go on and on but I will leave it there. You can thank the speculators for these unrealistic ridiculously inflated values!

Recently (while I have been watching the stock and bond markets) I have been asking myself: Where is all of the money coming from to support both bonds and stocks like this? The only answer I could even think of was that Europe might be fleeing to the safety of US investments as a result of their sovereign debt issues.

I concluded that there was no way it was sustainable and today we got some confirmation of this. We should also realize that one day does not make a trend. Especially in this whacky market!

Keep a close eye on the bond market as the Fed begins to pull out of MBS and Treasuries.

If appears that the bond vigilantes might begin to do their job. Health care reform may have been the straw that broke the camel's back. If you are in the long bond for yield, you might want to consider shorting Treasuries via TBT as a hedge.

Fasten your seatbelts folks! Things are about to get very interesting.

Disclosure: Long TBT in longer term accounts.