The United States is now setting a course to “boldly go where no man has gone before” as it pertains to the expansion of credit and the upcoming bull market in Treasury debt issuance. Basic economics 101 supports the view that a truckload of new Treasury debt issuance lies ahead to finance the enormous cost of the bank bailout and stem the tide of unrelenting home foreclosures. More supply means lower prices.

For long-term investors, betting against Treasury bonds might rank as one of the best speculations after more than 18 years of stock market beating gains as foreigners finally demand higher interest rate premiums to finance a gargantuan spending spree.

Severe Deflation

Global markets have violently transitioned from an inflationary environment since 2002 to aggressive deflation or falling prices since mid-July 2008.

Since July, the majority of asset classes, both domestic and international, have collapsed.

Stocks, bonds, commodities and real estate have all succumbed to severe losses over the last 90 days. The last time the world saw a similar panic accompanied by the rapid destruction of credit, equity and housing values was back in the 1930s. This is a frightening moment for the global investor.

The Death of Bonds

Despite big global bull markets from 2003 until mid-2007, equities have lagged Treasury bonds this decade.

U.S. Treasury bond yields have enjoyed a good decade since stocks peaked in March 2000. Bond yields have plummeted from almost 7% on the benchmark ten-year T-bond in 2000 to just under 4% now. Since 2000, intermediate-term Treasury bonds have gained more than 7% per annum versus a loss of 1.9% per annum for the S&P 500 Index.

While everything under the sun has imploded this year across global markets, U.S. and other major economy government bonds have posted strong returns; this party still has legs as deflation remains a constant heading into 2009, credit markets are still clogged and banks and hedge funds continue to hoard liquid securities like T-bills and bonds.

The curtains will eventually close on government bonds, especially U.S. long-term Treasury bonds as funding costs drive deficits through the roof once again.

The United States, Europe and other major economies are now targeting massive credit expansion to fund bank liabilities and save the financial system. They will ultimately succeed and the resultant nemesis won’t be deflation but aggressive inflation. This process won’t transform itself overnight, either. But as the desperate expansion of debt grows, I expect inflation to make a formidable comeback, probably starting in 2010 or 2011.

Increasingly, some of the best investment ideas will emerge from non-traditional sectors that are totally unconventional by investment management standards. And betting against Treasury bonds is almost a no-brainer for the next five years, possibly longer.

Chickens Coming Home to Roost

I have no doubt that over the next 12 months the U.S. long-term Treasury market will face higher interest rates. The funding required to fix the fractured financial system will be enormous, putting pressure on U.S. interest rates. Spending or bailout forecasts are still too conservative because most housing-related assets, including toxic mortgage-backed securities, are still declining in value.

It’s almost a “given” that long-term Treasury yields will rise for several years once this bout of deflation concludes.

So far foreigners have been willing to fund Treasury issuance and have been keen buyers of the dollar, but the privileges of being the reserve currency of the world can only be taken so far, as Great Britain painfully discovered after WW I.

On optimistic assumptions, at least $1 trillion dollars’ worth of Treasury’s will need to be issued during 2009 at a time when China and others will find their trade surpluses and therefore their capacity for buying more low yielding Treasury debt severely reduced. There may be pressure on both Treasury securities and the dollar as the growing cost of this bailout truly hits monstrous levels.

U.S. Spending Totally Out of Control

The Fed’s balance sheet has expanded by some $500 billion dollars alone over the last month to $1.5 trillion dollars. In all likelihood, that number will be much higher before December 31 and probably at least triple this amount in 12-18 months. Budget deficits are already in record territory and getting worse. The country continues to fight two wars and the cost of these protracted conflicts will add more pressure on the government’s deficit ceiling.

The partial or full nationalization of housing is another huge wildcard affecting America’s mortgage-backed rescue package.

The United States is bailing-out near-worthless mortgage-backed securities that have yet to bottom; housing is still in a freefall. The Paulson TARP plan (Troubled Asset Relief Program) and extensions of that bailout will probably cost much more than the original $750 billion proposed last month.

The Chinese, Japanese and other big lenders to the United States will eventually demand higher rates to compensate for the boom in Treasury supply issuance now underway. It’s also possible that many emerging market countries, net lenders to the U.S. Treasury this decade, will start to unwind these investments should the dollar begin to decline again.

Betting against long-term Treasury bonds over the next 3-5 years is a “Free Lunch” in the investment markets. The United States has no other choice but to spend its way out of deflation and grow inflation in the economy. Also, Treasury risk will rise considerably once the dollar starts falling again.

For the Fed and most European governments, there’s no other way out. It’s Print or Die.