Amid the worst economic contraction since 1982, bond yields should be plunging. But that’s certainly not the case since mid-January as Treasury bonds continue to decline in value. If the economy is so badly fractured then why are bond yields rising?

Since the beginning of the year the yield on the benchmark ten-year Treasury bond has surged almost 100 basis points from 2.25% to 3.03%. The 30-year T-bond has declined even more as yields have climbed from 2.68% on January 1 to 3.71%.

The obvious answer to this bond market enigma is supply and demand.

Despite a rapidly contracting U.S. economy since the fourth quarter, bond yields have continued to rise. Long bonds got hit again on Friday even as the government revised downward its 4th quarter GDP numbers showing a dizzy 6.2% contraction. When the numbers are this bad bond prices should be rising, not declining.

The world is increasingly becoming awash in Treasury supply. Bond yields in Europe are also rising, though not as aggressively as those in the United States.

If more than $2 trillion dollars of Treasury issuance isn’t bad enough to saturate the market then consider the deluge of bond supply also coming from Europe – more than $1.2 trillion dollars expected to hit the market in 2009 as the United Kingdom and the euro zone issue a frenzy of paper to cover massive fiscal spending plans and bailouts of their own.

Increasingly, it seems, investors can’t absorb the entirety of government bond supply.

The Treasury has been on steroids this year issuing a blitz of paper; more than $94 billion dollars has already been raised over the last two weeks alone. The Treasury has even reintroduced the one, three and seven year notes again this year to its menu as it seeks to raise cash to finance the government’s bulging spending plans.

The Fed has even warned the market that it won’t hesitate to buy back Treasury paper, if necessary or monetizing its debt. That ranks as potentially highly inflationary as the central bank will have to print money to absorb excess bond supply.

Another major problem for U.S. funding lies across the Pacific where America’s first and second largest Treasury investors, the Chinese and Japanese, are being squeezed by a collapse in exports and declining trade surpluses.

China, the biggest Treasury consumer by far, will need to recycle a fair share of its surpluses this year to boost domestic spending; it’s fair to assume that China won’t be able to absorb the same level of Treasury purchases as it did prior to the subprime collapse. That’s also putting pressure on Treasury yields.

I’m not sure exactly why U.S. Treasury bond yields are rising since the beginning of the year. It might be the Chinese and other foreign investors paring their purchases to fund their own domestic spending plans or just too much supply saturating the market.

Yet one thing seems certain: If bond prices can’t rally on a string of morbid economic data over the last eight weeks then something is seriously wrong with the Treasury market. Betting against or shorting long-term Treasury bonds remains a strong speculation over the next 36 months as the United States dumps trillions of dollars’ worth of supply onto the market. And too much supply isn’t a good thing.